SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549




FORM
10-K




x   ANNUAL REPORT
UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934





For the
fiscal year ended: DECEMBER 31, 2009





o   TRANSITION
REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934





For the
transition period from ______________ to ______________





Commission
File Number: 0-13092





SPECTRASCIENCE,
INC.


(Exact
name of registrant as specified in its charter)




MINNESOTA
            
            41-1448837(State
      of incorporation)
            
            (I.R.S.
      Employer Identification No.)




11568-11
      Sorrento Valley Road, San Diego, CA
            
            92121(Address
      of principal executive offices)
            
            (Zip
      Code)




Registrants’s
telephone number: (858) 847-0200





Securities
registered under Section 12(b) of the Exchange Act: NONE





Securities
registered under Section 12(g) of the Exchange Act:


COMMON
STOCK, $0.01 PAR VALUE


(Title of
Class)





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.




Yes            
o
            No
             x




Indicate by check mark if the
registrant is not required to file reports pursuant to Section 13 or 15(d) of
the Exchange Act.





Yes            
o
            No
             x





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months
(or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days.




Yes           
x
            No              
o




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).




Yes            
o
            No
             o




Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of Regulation S-K is not contained
herein, and will not be contained, to the best of registrant’s knowledge, in
definitive proxy or information statements incorporated by reference in Part III
of this Form 10-K or any amendment to this Form 10-K.





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company:




Large accelerated filer
             ̈
            Accelerated filer
             ̈
            Non-accelerated filer
             ̈
            Smaller reporting company
            x




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).





Yes            
o
            No
             x




The
aggregate market value of the voting Common Stock held by non-affiliates,
computed by reference to the price at which the voting Common Stock as of the
last business day of the Company’s most recently completed second fiscal quarter
is $22,855,193. There is no non-voting Common Stock.





As of
March 26, 2010 the number of outstanding shares of the Registrant’s Common
Stock, par value $0.01 per share, was 89,912,615.





DOCUMENTS
INCORPORATED BY REFERENCE





None.














SPECTRASCIENCE,
INC.





FORM
10-K


For
the Fiscal Year Ended December 31, 2009





TABLE OF
CONTENTS




PagePART
      IItem
      1. Business
              
              
              2Item
      1A. Risk Factors
              
              
              12Item
      1B. Unresolved Staff Comments
              
              
              19Item
      2. Properties
              
              
              19Item
      3. Legal Proceedings
              
              
              19Item
      4. (Removed and Reserved)
              
              
              19PART
      IIItem
      5. Market for Registrant’s Common Equity and Related Shareholder Matters
      and Issuer Purchases of  Equity Securities
              
              
              20Item
      6. Selected Financial Data
              
              
              21Item
      7. Management's Discussion and Analysis of Financial Condition and Results
      of Operations
              
              
              21Item
      7A. Quantitative and Qualitative Disclosures About Market
    Risk
              
              
              25Item
      8. Financial Statements and Supplementary Data
              
              
              28Item
      9. Changes in and Disagreements with Accountants on Accounting and
      Financial Disclosure
              
              
              41Item
      9A(T). Controls and Procedures
              
              
              41Item
      9B. Other Information
              
              
              42PART
      IIIItem
      10. Directors, Executive Officers and Corporate Governance
              
              
              42Item
      11. Executive Compensation
              
              
              44Item
      12. Security Ownership of Certain Beneficial Owners and Management and
      Related Shareholder
                Matters
              
              
              45Item
      13. Certain Relationships and Related Transactions and Director
      Independence
              
              
              47Item
      14. Principal Accounting Fees and Services
              
              
              47PART
      IVItem
      15. Exhibits and Financial Statement Schedules
              
              
              48SIGNATURES
              
              
              49




1




PART
I





ITEM 1.
BUSINESS.





Introduction





SpectraScience,
Inc. (“SpectraScience,” the “Company,” “we,” “our,” or “us”) was incorporated in
the State of Minnesota on May 4, 1983 as GV Medical, Inc. In October 1992, GV
Medical discontinued its prior business, refocused its development efforts and
changed its name to SpectraScience, Inc. The Company, along with its
wholly-owned subsidiary, Luma Imaging Corporation (“LUMA”), focuses on
developing its WavSTAT® Optical
Biopsy System (“WavSTAT”) and LUMA® Cervical
Imaging System. The WavSTAT and
LUMA are non-significant risk technologies that optically illuminate tissue in
real-time to distinguish between normal and pre-cancerous or cancerous
tissue.





Our
principal executive offices are located at 11568 Sorrento Valley Rd., Suite 11,
San Diego, CA 92121. You can reach us by telephone at (858) 847-0200; by fax at
(858) 847-0880; or by email at info@spectrascience.com. Our website address is
www.spectrascience.com, however the information contained on our web site is not
deemed to be a part of this document.





Reorganization





The
Company adopted “fresh-start reporting” effective August 2, 2004, given the
absence of any operating activity or other significant activity for almost two
years, in accordance with the guidelines of the A.I.C.P.A.’s Statement of
Position 90-7, “Financial Reporting by Entities in Reorganization Under the
Bankruptcy Code”.





Acquisition
of Luma Imaging Corporation Assets





On
November 6, 2007, the Company acquired 100% of the shares of Luma Imaging
Corporation from its shareholders in consideration for 11.2 million restricted
shares of SpectraScience common stock.





LUMA had
developed and received approval from the US Food and Drug Administration (the
“FDA”) for an optical, non-invasive diagnostic imaging system that is proven to
more effectively detect cervical cancer precursors than using conventional means
alone (i.e. colposcopy). The LUMA Cervical Imaging System utilizes a single-use
disposable probe and requires little additional training as it leverages
clinician’s existing skill sets. When used as an adjunct to colposcopy, the LUMA
system detects significantly more high-grade cervical cancer precursors than
colposcopy alone.




The
transaction was accounted for as an acquisition of assets that included
intellectual property, inventory and equipment. The intellectual property
consisted of a total of 34 issued US Patents and 28 additional patent
applications.




Products and
Markets




SpectraScience has developed a
technology platform to instantly determine if tissue is normal, pre-cancer or
cancerous, without the need for a physical biopsy. The Company has received FDA
approval to market its proprietary and patented optical biopsy system capable of
determining instantaneously whether colon tissue is normal, pre-cancerous or
cancerous without physically removing tissue from the body and without waiting
days for a pathology report. The Company has also developed an additional
application for the detection of pre-cancerous and cancerous tissue in the
esophagus, as well as recently expanded its product offerings to cervical cancer
and pre-cancer detection through the acquisition of Luma Imaging
Corporation.





The
WavSTAT operates by using cool, safe UV laser light to optically illuminate and
analyze tissue, enabling the physician to make an instant diagnosis during
endoscopy when screening for cancer and, if warranted, to begin immediate
treatment during the same procedure. The SpectraScience WavSTAT uses
laser-induced auto-fluorescence to obtain spectral information from tissue at
the suspected site. The system is classified as a non-significant risk device
which transmits low-level UV laser light energy through an optical fiber to the
tissue via the working channel of an endoscope. The tissue in contact with the
optical fiber absorbs the light and the resulting tissue auto-fluorescence is
collected by the same optical fiber and returned to a detector within the
WavSTAT console for measurement. The system analyzes the spectral data and
displays the results graphically for the user as normal tissue (green light),
suspected pre-cancer, or cancer (red light). Data are recorded on a printer and
saved in flash memory and a hard drive. The WavSTAT has been tested at five
leading medical centers, including the Mayo Clinic and Massachusetts General
Hospital, with results demonstrating statistically significant improvement in
physician accuracy in the ability to detect pre-cancerous and cancerous tissue
during endoscopy.


2





The
WavSTAT was specifically designed to serve as a technology platform to
facilitate multiple medical applications for cancer detection. We see additional
opportunities for this core technology in several other large as-yet-unexplored
markets which include lung, skin, oral, prostate, breast, urinary, stomach, IBD
and bladder cancer detection. The Company is currently developing additional
applications of its platform for these markets, and is analyzing feasibility of
the use of our technology and the revenue opportunity for each
market.




Colorectal
Cancer





The
American Cancer Society reports colorectal cancer as the third most common
cancer diagnosed in the US with approximately 108,000 new cases annually. With
an estimated 49,960 deaths in 2008, colorectal cancer is second only to lung
cancer as the leading cause of cancer death in the US. Candidates for colorectal
cancer screening include all persons, with or without symptoms, over the age of
50 (or an estimated 80-90 million people in the US) with the screening market
expected to increase 20% over the next ten years. Demographic trends in Europe
are very similar.





Colorectal
cancer is primarily diagnosed through the discovery and histo-pathologic
analysis of polyps. Colon polyps are small masses of tissue found in the lining
of the colon that may be either benign or malignant. The most commonly performed
and generally accepted colorectal cancer screening procedure to detect polyps is
an endoscopy of the lower colon also known as a flexible sigmoidoscopy or,
alternately, a full colonoscopy. According to the American Society for
Gastrointestinal Endoscopy guidelines for colorectal cancer screening, large
polyps (greater than 1 centimeter) are generally removed as a matter of course
and sent to pathology for evaluation. On the other hand, the guidelines further
state that small polyps (less than 1 centimeter which account for approximately
85% of all polyps) require, "individualized treatment on a case by case basis".
The clinical utility of the WavSTAT occurs when the physician must decide the
best course of treatment for small polyps. When small polyps are found, it is
left to the physician's discretion based primarily on visual assessment, whether
to remove the polyp, place the patient under surveillance, or to biopsy. If a
biopsy is performed and cancer or pre-cancer is documented by pathology, the
polyp must then be removed during a second costly endoscopy
procedure.





Relative
to colorectal cancer, five-year survival rates as reported by the American
Cancer Society are as follows:





·
            Approximately
      90% of patients live five years or longer if the cancer is detected and
      treated at an early stage;




·
            Only
      68% of patients live five years or longer if the cancer spreads outside
      the polyp and colon to nearby organs or lymph nodes;
  and




·
            The
      five-year survival rate for those patients in whom the cancer has spread
      further to the liver or other organs is only
  10%.




Early
detection of colorectal cancer is essential to long-term survival.
Unfortunately, the American Cancer Society reports that only 39% of colorectal
cancers are detected at an early stage. Clinical studies indicate that
colorectal cancer screening procedures result in earlier detection and can
prevent as many as 20 to 40% of potential colorectal cancers and subsequently
reduce colorectal cancer deaths by 30 to 50%. Colorectal screening procedures
not only save lives, they also save money. If a patient is not diagnosed until
symptoms develop and the disease has spread, or if misdiagnosed at an early
stage, the chance of patient survival plummets and more advanced treatment
regimens such as surgery, chemotherapy and/or radiation become
necessary.





The
WavSTAT was specifically designed to be used during screening endoscopy of the
colon to aid and improve the physician's ability to identify small polyps as
normal, pre-cancerous or cancerous tissue in real time. Results from the
Company's FDA regulated clinical studies performed at the Mayo Clinic
(Rochester, MN), Massachusetts General Hospital (Boston, MA), Hennepin County
Medical Center (Minneapolis, MN) and Minnesota Gastroenterology P.A. (St. Paul
and Minneapolis, MN) demonstrated that using the WavSTAT during colorectal
endoscopic screening increased the physician's diagnostic accuracy in detecting
pre-cancerous or cancerous polyps by a statistically significant
amount.





Based on
the results demonstrated by these clinical studies, we believe that using the
WavSTAT will:





·
            Significantly
      improve the physician's diagnostic accuracy in determining whether small
      polyps in the colon are pre-cancerous or cancerous;·
            Improve
      patient survival rates by earlier detection and treatment of cancers, and
      more importantly pre-cancers, by more accurately identifying cancers or
      pre-cancers the physician may misdiagnose;·
            Improve
      the patient's quality of life by providing an immediate analysis of the
      tissue, thereby eliminating the anxiety of waiting several days to hear
      the pathology results;·
            Enable
      the physician to diagnose and treat the patient during the same endoscopy
      procedure with the same biopsy instrument, thereby potentially reducing
      the need for scheduling a second expensive endoscopy for treatment
      purposes;·
            Significantly
      reduce the number of physical biopsies performed and reduce the number of
      unnecessary follow-on endoscopies performed;
and




3





·
            Reduce
      the number of misdiagnosed patients, thereby eliminating the need for more
      costly advanced treatments such as surgery, chemotherapy and/or
      radiation.




Esophageal
Cancer





Barrett’s
esophagus is a condition of the lining of the lower esophagus thought to be
caused primarily by Gastro Esophageal Reflux Disease (“GERD”), more commonly
known as chronic heartburn. Barrett’s esophagus is considered to be a
pre-malignant stage and a precursor to esophageal cancer. Physicians typically
recommend that persons with chronic heartburn should have an endoscopy to look
for Barrett’s esophagus. Some Barrett’s patients will advance further to a stage
where additional abnormal tissue called dysplasia is present. Dysplasia is known
to be the next progressive step toward esophageal cancer and is categorized as
either low-grade or high-grade.





Barrett’s
esophagus, dysplasia and esophageal cancer patients are presently diagnosed via
endoscopy of the esophagus with the physician taking multiple random physical
biopsies of the esophageal lining; this is a significantly invasive procedure.
It is critical that high-grade dysplasia is correctly diagnosed because
physicians frequently recommend surgical resection or removal of the esophagus
in such an event. Unfortunately, dysplasia is difficult to find and/or diagnose
because it is not reliably visible to the physician during standard endoscopy.
The result is that physical biopsies (as many as 20 at once) are performed
either randomly or in a geometric pattern in the esophagus in the hope of
finding any diseased tissue. Current medical practice typically follows the
guidelines described below:





·
            Patients
      with chronic GERD (severe heartburn) receive a screening endoscopy of the
      esophagus with multiple biopsies to check for Barrett's
      esophagus;




·
            Patients
      with Barrett's esophagus receive an endoscopy with multiple biopsies every
      year to check for dysplasia;




·
            Patients
      with Barrett's esophagus that has progressed to include low-grade
      dysplasia receive an endoscopy with multiple biopsies every six months to
      check for high-grade dysplasia; and




·
            Patients
      with Barrett's esophagus that has progressed to include high-grade
      dysplasia receive an endoscopy with multiple biopsies every three months
      to check for cancer and/or may be referred for esophageal surgical
      resection, photodynamic therapy or electrical (RF)
    ablation.





The
relatively high death rate associated with esophageal cancer typically results
from a lack of early diagnosis with the outcome being that the cancer has grown
to an advanced stage. As described above, the frequency of endoscopic
surveillance for these patients increases as the pre-cancerous stages advance in
hopes of providing the earliest possible diagnosis.





The
Company has developed an application for the WavSTAT for the detection of
pre-cancerous and cancerous tissue in the esophagus. We completed a clinical
study in April 2002 using our WavSTAT for the detection of pre-cancerous and
cancerous tissue in the esophagus. The study was designed to determine the
viability of using spectroscopic techniques to detect esophageal cancer in
Barrett's esophagus patients, and to develop and demonstrate the feasibility of
the WavSTAT for this type of application. A total of 87 patients with Barrett's
esophagus were enrolled into the trial with 326 optical and physical biopsies
taken. The results of the evaluation show that we were able to obtain a
sensitivity of 95% and a specificity of 80% in determining high-grade versus
low-grade dysplasia or non-dysplastic Barrett's esophagus, suggesting that the
WavSTAT is effective in detecting pre-cancerous and cancerous tissue. Derived
from the study data, an initial proprietary tissue recognition software
algorithm was developed and is being used in current European trials. We
continue to enroll additional patients to improve the algorithm. The WavSTAT
with the initial esophageal algorithm has been released for limited sale in the
European Union (the “EU”).





We
estimate the annual potential revenue for esophageal cancer and pre-cancer
detection in the US and EU to be $850 million with the related annual
disposable/re-useable market estimated at an additional $250-650
million.




Cervical
Cancer




In the
U.S., more than four million women have abnormal PAP tests each year, and they
typically undergo a series of repeat, stressful and expensive diagnostic tests.
For women with precancerous lesions, the long diagnostic cycle can allow the
disease to progress and develop into invasive, life-threatening cancer. By
providing a more definitive objective test, it is expected that LUMA will allow
clinicians to more effectively manage and treat millions of women who are at
risk of cervical cancer.




The LUMA
provides a, non-invasive diagnostic imaging system to detect cervical cancer
precursors more effectively than using conventional means alone (i.e.
colposcopy). The LUMA utilizes a single-use disposable probe and requires little
additional training as it leverages clinicians’ existing skill sets. When used
as an adjunct to colposcopy, LUMA detects significantly more high-grade cervical
cancer precursors. Clinical trials comprised of over 3,000   women have
demonstrated LUMA’s ability to detect close to 30% more Atypical Squamous Cell
of Undetermined Significance/Low-grade Squamous Intraepithelial Lesion
(“ASCUS/LSIL”) cancer cell precursors than colposcopy alone. LUMA received FDA
approval as an adjunct to colposcopy in March 2006 and the predecessor company
was conducting a 950 patient post-approval study (300 were completed) to further
examine its advanced detection capabilities when placed in a practical clinical
setting.


4




In the
U.S. alone, over $6 billion is spent annually on the screening, diagnosis and
treatment of women with cervical cancer. The current colposcopy market is
approximately $1.0 billion annually. Diagnosing cervical cancer is often a long
and uncertain process, requiring repeat visits by anxious patients.
Approximately two million colposcopy procedures are performed each year in the
United States, with many repeat exams aimed at arriving at a definitive
diagnosis. The introduction of HPV-DNA testing is expected to be a catalyst for
this market, increasing the number of colposcopy procedures performed each year.
We believe that the LUMA System is a reliable, easy to use diagnostic tool that
provides immediate benefits for clinicians and their patients by reducing the
incidence of misdiagnosis and allowing for early-stage detection and treatment
of cervical cancer precursors.





Government
Regulation





United
States





Extensive
government regulation, both in the United States and internationally, controls
the design, manufacture, labeling, distribution and marketing of our products,
particularly regarding product safety and effectiveness. In the United States,
medical devices are subject to review and clearance or approval by the Food and
Drug Administration (FDA). The FDA regulates the clinical testing, manufacture,
labeling, distribution and promotion of medical devices. If we fail to comply
with applicable requirements, we could face:




·
            fines,
      injunctions or civil penalties;




·
            recall
      or seizure of our products;




·
            criminal
      prosecution;




·
            a
      recommendation that we not be allowed to contract with the
      government;




·
            total
      or partial suspension of
production;




·
            inability
      to obtain pre-market clearance/approval for our devices;
    and




·
            withdrawal
      of marketing approvals





The Food,
Drug, and Cosmetic Act, the Public Health Service Act, and Safe Medical Devices
Act of 1990 and other federal statutes and regulations also govern or influence
the testing, manufacture, safety, labeling, storage, recordkeeping, clearance,
advertising and promotion of such products.




In the
United States, medical devices are assigned to one of three classes depending on
the controls the FDA deems necessary to ensure the safety and effectiveness of
the device. The WavSTAT and LUMA are both Class III devices; this is FDA’s most
highly regulated category in the Center for Devices and Radiological Health
(“CDRH”) guidelines. In addition to adhering to general controls to which all
medical devices are subject, and special controls such as performance standards,
post-market surveillance and patient registries, a Class III device must receive
pre-marketing approval to ensure its safety and effectiveness prior to
commercialization.




FDA
approval to distribute regulated devices can be obtained in one of two ways. If
a new or significantly modified device is “substantially equivalent” to an
existing legally marketed device, the new device can be commercially introduced
after filing a 510(k) pre-market notification with the FDA and the subsequent
issuance by the FDA of an order permitting commercial distribution. Changes to
existing devices that do not significantly affect safety or effectiveness may be
made without an additional 510(k) notification. We received 510(k) clearance
from the FDA for our disposable and reusable Optical Biopsy Forceps in December
1996.




A second,
more comprehensive approval process applies to a Class III device that is not
substantially equivalent to an existing product. First, the applicant must
usually conduct clinical trials in compliance with testing protocols and patient
“informed consent” forms approved by the Institutional Review Board (“IRB” or
the “Safety Committee”) at each participating research institution. These boards
oversee and approve all clinical studies at their institutions (in some cases a
central IRB may approve studies at multiple locations). Second, a Pre-Market
Approval (PMA) application must be submitted to the FDA describing (i) the
clinical trial results, (ii) the device and its components, (iii) the methods,
facilities and controls used for manufacture of the device, (iv) proposed
labeling and advertising literature, and (v) the demonstration that the product
is safe and effective.




If the
FDA determines, upon receipt of the PMA application, that the application is
sufficiently complete to permit a substantive review, they will accept the
application for filing. Review of a PMA typically takes from six months to two
years from the date the application is accepted for filing, but can be
significantly longer. Often, during the review period, a panel primarily
composed of clinicians and acting as an advisory committee will be convened to
review, evaluate, and provide non-binding recommendations to the FDA as to
whether the device should be approved. Toward the end of the application review
process, the FDA generally will conduct an inspection of the manufacturer’s
facilities to ensure that the facilities are compliant with the applicable
Quality System Regulations requirements.


5




If FDA
evaluations of both the PMA application and the manufacturing facilities are
favorable, the FDA will issue either an approval letter or a conditional
approval letter which contains a number of conditions that must be satisfied in
order to secure final approval of the PMA application. When and if those
conditions are fulfilled to the satisfaction of the FDA, they will issue an
approval letter, authorizing commercial marketing of the device for certain
indications for use. If the FDA’s evaluation of the PMA application or
manufacturing facilities is not favorable, the FDA will deny approval of the
application or issue a “not approvable letter.” The FDA may also determine that
additional clinical trials are necessary, in which case pre-market approval
could be delayed for several years while additional clinical trials are
conducted and submitted in an amendment to the PMA application. The pre-market
approval process can be expensive, uncertain and lengthy, and a number of
devices for which FDA approval has been sought have never been approved for
marketing.




Any
products manufactured or distributed pursuant to FDA clearances or approvals,
are subject to pervasive and continuing regulation by the FDA, including
record-keeping requirements and reporting of adverse experiences when using the
product.




Device
manufacturers are required to register their establishments and list their
devices with the FDA and certain state agencies, and are subject to periodic
inspections. The Food Drug and Cosmetic Act requires devices to be manufactured
in accordance with Quality System Requirements regulations, which impose
procedural and documentation requirements upon a manufacturer and any of its
contract manufacturers with respect to manufacturing and quality assurance
activities. The frequency and depth of inspections of PMA products are generally
more detailed and frequent than products cleared in the 510(k) process. The past
two inspections by the FDA did not result in any adverse findings. Quality
System Requirements regulations also require design controls and maintenance of
service records. Changes in existing requirements or adoption or new
requirements or policies could adversely affect our ability to comply with
regulatory requirements. Failure to comply with regulatory requirements could
have a material adverse effect on our business, financial condition or results
of operations.





The
Company submitted a PMA for market clearance of the WavSTAT Optical Biopsy
System for use during endoscopic screening of the colon in September 1998, and
was approved by the FDA in November 2000. Based upon beta site outcome clinical
studies, features were added to the WavSTAT, and submitted as a supplement to
the original filing in September 2001. The supplement for the WavSTAT II was
approved by the FDA in November 2001. The Company submitted a supplement for
approval of WavSTAT III in February 2002 and approval was received in August
2002. We anticipate that product improvements requiring approval, or any new
applications, such as for Barrett’s esophagus developed for the WavSTAT will be
submitted as supplements to the original filing rather than as original PMA
filings. In September 2009, the FDA approved a PMA amendment for an updated
WavSTAT III platform which included new state-of-the-art hardware.





A similar
path was followed for the LUMA Cervical Imaging System with the original PMA
being filed by FDA on June 28, 2004. Following interactive communication with
FDA and 15 PMA amendments, the product received its PMA approval on March 16,
2006. In addition to the standard conditions of approval, an additional LUMA
approval condition was a post-approval study. When the LUMA assets were
acquired, approximately one third of the study had been completed. We have
continued the post-approval study to meet this condition of
approval.





We are
also subject to numerous federal, state and local laws relating to such matters
as safe working conditions, manufacturing practices, environmental protection,
fire hazard control and disposal of hazardous or potentially hazardous
substances. We are not aware of any manufacturing methods for the WavSTAT or
LUMA Systems that will require extensive or costly compliance with environmental
regulations. However, since laws change over time there can be no assurance that
(i) we will not be required to incur significant costs to comply with all
applicable laws and regulations in the future, or (ii) the impact of changes in
those laws or regulations or adoption of new laws and regulations will not have
a material adverse effect upon our ability to do business.





European
Union and Other Countries





The
European Union encompasses most of the major countries in Europe. The European
Union has adopted numerous directives and standards regulating the design,
manufacture, clinical trial, labeling, and adverse event reporting for medical
devices. The principal directive prescribing the laws and regulations pertaining
to medical devices in the European Union is the Medical Devices Directive,
93/42/EEC.





Devices
that comply with the requirements of the Medical Devices Directive will be
entitled to bear the CE mark, indicating that the device complies with the
essential requirements of the applicable directive. In order to distribute a
medical device in the European Union, the product must earn and display the CE
mark. Generally, companies must also go through the ISO certification process in
order to obtain the CE mark. SpectraScience received ISO 9001 certification in
July 2000, and CE mark authorization for our products in October 2000. In order
to maintain ISO 9001 certification SpectraScience must undergo a yearly audit to
assure the European Union regulatory agencies of our compliance with ISO 9001
standards. Our last audit was in 2007, when we earned certification for an
additional standard, EN 13485:2003, which is a medical device adaptation of the
ISO 9001 standard. We are periodically re-audited to remain ISO 9001 and EN
13485 certified. There can be no assurance that we will be able to maintain
international certification or CE mark authorization for any of our products or
product components. Furthermore, even though a device bears the CE Mark,
practical complications may arise with respect to market introduction because of
differences among countries in areas such as labeling requirements and
reimbursement practices. We may be required to spend significant amounts of
capital in order to comply with the various regulatory requirements of foreign
countries and achieve reasonable payment for our products.


6




Product
Research and Development





The
Company invested similar capital in research and development for the fiscal year
ended December 31, 2009 as compared to prior recent history. The slight decrease
was as a result of increased clinical trial activity, the further development of
the Barrett's esophagus software algorithm offset by the transition to producing
systems for sale, rather than for clinical trials. Research and development
expenses were approximately $2,127,000 and $2,220,000 for the fiscal years ended
December 31, 2009 and 2008, respectively. In 2009 the Company recognized
approximately $761,000 of non-cash expense related to the impairment of
LUMA  assets classified as long lived assets (equipment) as well as
approximately $100,000 in non-cash WavSTAT inventory obsolescence
expense.





Compliance
with Environmental Laws





Management
has reviewed the cost of compliance with environmental laws and deemed the cost
of such appliance to be non-material for the fiscal year ended December 31, 2009
and the foreseeable future.





Distribution,
Sales and Customers





Our
objective is to become a leader in the development and commercialization of
advanced proprietary diagnostic products with the capability to differentiate in
real-time between healthy, and pre-cancerous or cancerous tissue. During 2009,
our sales and marketing efforts have been, and will continue to be focused on
selling, leasing or renting the WavSTAT and LUMA Systems in the colorectal,
cervical and esophageal cancer diagnostic markets. We envision particular
emphasis on selling the WavSTAT System in international markets.





In the United States, successful
product introduction will require a larger direct sales force or a strategic
corporate partner that has strongly established call patterns within Managed
Care Organizations. Management believes the availability of clinical support
specialists to support the sales force, and to conduct training seminars to
educate endoscopists and other health care providers regarding proper use of the
WavSTAT and LUMA Systems will be a strong component of a product introduction
strategy. To further international objectives during 2010, the Company will
continue to appoint new European Distributors. The distributors should have
significant resources and strong franchises which, when coupled with our
technology, will increase the likelihood of commercial success in those
markets.




Third-Party
Reimbursement




We expect
to market and sell the WavSTAT and LUMA Systems primarily through hospitals and
clinics. In the United States, the purchasers of medical devices generally rely
on Medicare, Medicaid, private health insurance plans, health maintenance
organizations and other sources of third party reimbursement for health care
costs, to reimburse all or part of the cost of medical devices and/or the
procedure in which the medical device is used. Significant sales of the our
Systems will, in part, be dependent on the availability of adequate
reimbursement from these third party payers for procedures carried out using our
products. We believe that less invasive procedures generally provide less costly
overall therapies compared to conventional drugs, surgery and other treatments.
We anticipate hospital administrators and physicians will justify the use of our
products by the cost and time saving recognized and clinical benefits that we
believe will be derived from the use of our products.




Third
party payers determine whether to provide coverage for a particular procedure
and reimburse health care providers for medical treatment at a fixed rate based
on the diagnosis-related group established by the Center for Medicare and
Medicaid Services. The fixed rate of reimbursement is based on the procedure
performed and is unrelated to the specific type or number of devices used in a
procedure. If a procedure is not covered by a diagnosis-related group, payers
may deny reimbursement. If reimbursement for a particular procedure is approved,
third party payers will reimburse health care providers for medical treatment
based on a variety of methods, including a lump sum prospective payment system
based on a diagnosis-related group or per diem, a blend between the health care
provider’s reported costs and a fee schedule, a payment for all or a portion of
charges deemed reasonable and customary, or a negotiated per capita fixed
payment.




Upon
product introduction, currently existing available codes can be used to provide
a level of reimbursement to users. Management believes however, that currently
available reimbursement codes do not adequately reimburse for the anticipated
value that optical biopsy technology brings to the medical care system. Optical
biopsies are not currently approved for reimbursement by third-party payers, and
there can be no assurance that optical biopsy technology will be approved for
any third party reimbursement, even if it proves to play a significant role in
improving the endoscopist’s ability to accurately differentiate among polyps in
the colon, Barrett’s esophagus or cervical dysplasia, thereby leading to early
detection and subsequent treatment.




Medical
equipment capital costs incurred by hospitals are reimbursed separately from
diagnosis-related group payments. Changes in federal legislation, or policies of
the government or third-party payers that reduce reimbursements under capital
cost pass through-systems, could adversely affect the market for our
products.


7




As stated
previously, demonstrating cost-effectiveness and improved patient outcomes is
critical to the sales cycle since payers evaluate these factors in determining
whether to reimburse for new technologies. Payers may also delay reimbursement
decisions for a year or more, even when provided with cost-effectiveness data,
while they conduct their own technology assessments. The availability of
peer-reviewed literature regarding the technology may help payers in reducing
this technology assessment timeline. To promote the dissemination of literature
regarding the WavSTAT, LUMA and optical biopsy technology, SpectraScience
intends to have published clinical utility data in peer-reviewed
journals.




We expect
that there will be continued pressure on cost-containment throughout the United
States health care system. Cost reduction, cost containment, managed care, and
capitation pricing (putting a ceiling on the price) are very familiar themes
within healthcare. Limits on third-party reimbursements that lead to cuts in
reimbursements for new or experimental procedures would affect the ability of
smaller companies with new technologies to compete with larger established firms
or with established technologies. Lobbying activities are often necessary to
bring to light the value of these new technologies but require extensive amounts
of corporate resources that the Company may not be able to afford.




Reimbursement
systems in international markets vary significantly by country and by region
within some countries, and reimbursement approvals must be obtained on a
country-by-country basis. Many international markets have government managed
health care systems that control reimbursement for new products and procedures.
In most markets, there are private insurance systems as well as government
managed systems. Market acceptance of our products will depend on the
availability and level of reimbursement in international markets we target.
There can be no assurance that we will obtain reimbursement in any country
within a particular time, for a particular time, for a particular amount, or at
all.




We are
unable to predict what additional legislation or regulation relating to the
health care industry or third-party coverage and reimbursement may be enacted in
the future, if any, or what effect it might have on us. In particular, we are
unable to yet predict the impact that recently signed healthcare reform
legislation will have on our business. Reforms may include (i) mandated basic
health care benefits, (ii) controls on health care spending through limitations
on the growth of private health insurance premiums and Medicare and Medicaid
spending, (iii) greater reliance on prospective payment systems, (iv) the
creation of large insurance purchasing groups, and (v) fundamental changes to
the health care delivery system. Management anticipates that Congress and state
legislatures will continue to review and assess alternative health care delivery
systems and payment mechanisms. Due to uncertainties regarding the ultimate
features of reform initiatives and their enactment and implementation, we cannot
predict which reform proposals, if any, will be adopted, when they may be
adopted or what impact they may have on us. Failure by hospitals and other users
of our products to obtain reimbursement from third-party payers, or changes in
government and private third-party payers’ policies toward reimbursement for
procedures employing our products, could have a material adverse effect on our
business, financial condition and results of operations.




Manufacturing
and Sources of Supply





SpectraScience
manufactures the WavSTAT and LUMA Systems at its facility in San Diego. The
WavSTAT forceps are outsourced to United States contract OEM manufacturers. At
the present time, SpectraScience performs the manufacturing of the optical fiber
portion of the forceps in-house. The Company also performs certain final
assembly processes of the WavSTAT forceps. All WavSTAT and LUMA Systems
previously used for pre-clinical testing, FDA compliant clinical trials, and
cost effectiveness/outcome clinical studies were manufactured under a Quality
System with Standard Operating Procedure controls. Management continues to
utilize these quality control Systems and adds to or modifies them as
necessary.





The
WavSTAT and LUMA Systems are, and will be, manufactured in accordance with
current FDA Quality System Regulations and ISO 9001 International Standards,
both of which are necessary to sell products within the United States and the
European Union. These requirements impose certain procedural and documentation
requirements upon SpectraScience with respect to manufacturing and quality
assurance activities, as well as upon those third parties with whom the Company
contracts to perform certain manufacturing processes.





During
the third quarter of 2007, SpectraScience was granted ISO 9001 and 13485:2003
certification for its manufacturing facility and Quality System. These
international standards are the European equivalent to the FDA’s Quality System
Regulations. Meeting these standards permits use of the “CE mark” to export the
WavSTAT optical biopsy system to the European Union and most other countries of
the world.





The
manufacturing processes and Standard Operating Procedures required to build a
WavSTAT and LUMA System have been reviewed by the FDA and we are authorized to
manufacture the product in our current facility.   Both the FDA
and the European Notified Body will continue to perform periodic audits as long
as SpectraScience manufactures and commercializes medical products





Competition





The
medical device industry is highly competitive. Management believes the Company
has few direct competitors in applying spectroscopy for the differentiation of
normal, pre-cancerous or cancerous tissues in the gastrointestinal tract;
however, the development of products using spectroscopic diagnostics for various
medical specialties is rapidly growing. To the best of our knowledge, no other
competitors have completed FDA clinical studies or submitted a pre-market
approval application to the FDA or received CE Mark authority to distribute a
product for the detection of colorectal or esophageal cancer.


8




Many
competitors have substantially greater resources than we do, either internally
or in combination with strategic partners. These resources may allow them to
develop, market and distribute technologies or products that could be more
effective than those developed or marketed by us, or that would render our
technologies and products obsolete. The resource advantages they may have
are:





·
            greater
      capital resources;·
            greater
      manufacturing resources;·
            greater
      resources and expertise in testing products in clinical
      trials;·
            greater
      resources and expertise in the areas of research and
      development;·
            greater
      expertise in obtaining regulatory approvals; and·
            greater
      resources for marketing and sales
activities.





The
companies listed below have developed or are in the process of developing
products that use light-based spectroscopic technology. They could potentially
compete with SpectraScience products or technologies. Although none of these
companies uses a technology or method which is the same as the SpectraScience
technologies and methods.




·
            Sensivida
      Medical has been engaged in the design and development of medical
      diagnostic instruments that detect cancer in vivo in humans by using light
      to excite the molecules contained in tissue and measuring the differences
      in the resulting natural fluorescence between cancerous and normal
      tissue.  Effective March 3, 2009, with the merger of Sensivida
      Medical Systems, Inc. into the company’s wholly-owned subsidiary
      BioScopix, Inc., the company’s technology will also focus on the
      automation of analysis and data acquisition for allergy testing, glucose
      monitoring, blood coagulation testing, new tuberculosis testing, and
      cholesterol monitoring.




·
            Electro-Optical
      Sciences, Inc. is focused on the design and development of a non-invasive,
      point-of-care instrument to assist in the early diagnosis of melanoma.
      MelaFind® features a hand-held imaging device that emits multiple
      wavelengths of light to capture images of suspicious pigmented skin
      lesions and extract data. The data is then analyzed against its
      proprietary database of melanomas and benign lesions using sophisticated
      algorithms in order to provide information to the physician and produce a
      recommendation of whether the lesion should be biopsied. MelaFind is
      currently in clinical trials.





·
            Guided
      Therapeutics, Inc. is a medical technology company focused on developing
      medical devices that have the potential to improve health care. The
      technology, including products in research and development, includes: a)
      biophotonics technology for the non-invasive detection of cancers,
      including cervical cancer, b) methods of sampling interstitial fluid using
      laser energy to create micropores for improved glucose and alcohol
      monitoring and c) methods of delivering insulin to people with diabetes
      with a SimpleChoice® product line. In 2007, the company sold its insulin
      delivery business and will focus on completing the development of their
      cervical cancer detection device.·
            STI
      Medical Systems is developing what it calls Hyperspectral Diagnostic
      Imaging (HSDI®) for use in detecting cervical cancer and other cancers.
      HSDI® is claimed to be a unique, high-tech blend of spectral and spatial
      imaging and image processing, exploiting biochemical phenomenology to
      address unmet diagnostic needs. HSDI utilizes Virtual Biopsy® technology
      to automatically capture and analyze data using a combination of
      high-resolution digital imagery, tissue fluorescence imagery and
      white-light reflectance imagery. Advanced computer aided diagnosis
      algorithms use these data to detect, classify and localize cancer and
      cancerous tissue with accurate delineation of disease margins. It is
      unknown if the company has tested the product on patients with sufficient
      volume to make an FDA filing.




9





Patents





SpectraScience
currently owns exclusive rights to a total of eight issued US patents and
international patents for the WavSTAT technology.





Patent
      Name
                
                U.S. Patent
                  NumberOptical
      Biopsy Forceps
                
                
                5,762,613System
      for Diagnosing Tissue with Guidewire
                
                
                5,601,087Method
      of Diagnosing Tissue with Guidewire
                
                
                5,439,000Guidewire
      Catheter and Apparatus for Diagnostic Imaging
                
                
                5,383,467Optical
      Biopsy Forceps System and Method of Diagnosing Tissue
                
                
                6,066,102Optical
      Biopsy Forceps
                
                
                6,129,683Optical
      Biopsy System and Methods for tissue Diagnosis
                
                
                6,174,291Optical
      Forceps System and Method of Diagnosing and Treating
Tissue
                
                
                6,394,964




SpectraScience
is also the exclusive licensee through the Massachusetts General Hospital of US
Patent 5,843,000 entitled, “Optical Biopsy Forceps and Method of Diagnosing
Tissue” and a pending international patent application. The above patents expire
between January 2015 and May 2022. Each of the international patents designates
several countries for patent protection.





SpectraScience
currently owns exclusive rights to a total of 34 issued US patents and
international patents for the LUMA technology.





Patent
      Name
                
                U.S. Patent
                  NumberSpectral
      Volume Microprobe Analysis of Materials
                
                
                5,713,364Spectral
      Volume Microprobe Arrays
                
                
                6,104,945Sheath
      for Cervical Optical Probe
                
                
                D453,832Sheath
      for Cervical Optical Probe
                
                
                D453,962Sheath
      for Cervical Optical Probe
                
                
                D453,963Sheath
      for Cervical Optical Probe
                
                
                D456,964Spectroscopic
      System Employing a Plurality of Data Types
                
                
                6,385,484Spectral
      Volume Microprobe Arrays
                
                
                6,411,835Systems
      and Methods for Optical Examination of Samples
                
                
                6,411,838Spectral
      Data Classification of Samples
                
                
                6,421,553Optical
      Methods and Systems for Rapid Screening of the Cervix
                
                
                6,427,082Sheath
      for Cervical Optical Probe
                
                
                D460,821Substantially
      Monostatic, Substantially Confocal Optical Systems for Examination of
      Samples
                
                
                6,760,613Fluorescent
      Fiberoptic Probe for Tissue Health Discrimination and Method of Use
      Thereof
                
                
                6,768,918Method
      and Apparatus for Identifying Spectral Artifacts
                
                
                6,818,903Spectral
      Volume for Microprobe Arrays
                
                
                6,826,422Sheath
      for Cervical Optical Probe
                
                
                D507,349System
      for Normalizing Spectra
                
                
                6,839,661Optical
      Probe Accessory Device for Use In-Vivo Diagnostic
    Procedures
                
                
                6,847,490Methods
      of Monitoring Effects of Chemical Agents on a Sample
                
                
                6,902,935Sheath
      for Cervical Optical Probe
                
                
                D500,134Optimal
      Windows for Obtaining Optical Data for Characterization of Tissue
      Samples
                
                
                6,933,154Methods
      and Apparatus for Displaying Diagnostic Data
                
                
                7,136,518Spectral
      Volume Microprobe Analysis of Materials
                
                
                5,813,987Colonic
      Polyp Discrimination by Tissue Florescence and Fiberoptic
      Probe
                
                
                7,103,401Optical
      Methods and Systems for Rapid Screening of the Cervix
                
                
                7,127,282Methods
      and Systems for Correcting Image Misalignment
                
                
                7,187,810Image
      Processing using Measures of Similarity
                
                
                7,260,248Methods
      and Apparatus for Processing Spectral Data for use in Tissue
      Characterization
                
                
                7,282,723Methods
      and apparatus for characterization of tissue samples
                
                
                7,309,867Fluorescent
      fiberoptic probe for tissue health discrimination
                
                
                7,310,547Methods
      and Systems for Correcting Image Misalignment
                
                
                7,406,215Unique
      Methods of Calibrating Spectral Data
                
                
                7,459,696Unique
      Methods and Apparatus for Evaluation of Image Focus
                
                
                7,469,160





An
additional 18 patent applications are pending. The above patents expire between
2015 and 2022. In total, more than 500 valid claims have been granted covering a
broad range of technology and methods. Foreign rights have further been secured
for many of the most important patents.




SpectraScience
believes that it holds the single largest patent portfolio of its kind in the
field of optical methods for identifying tissue abnormalities, particularly for
identifying cancer and its precursors. The Company also believes that its
portfolio will protect the core technology and methods embodied in the LUMA and
WavSTAT Systems and for many of its foreseeable product extensions and will
create a substantial barrier to entry for others pursuing similar
approaches.




Core
Areas of Patent Protection




More
specifically, SpectraScience’s portfolio provides protection in the following
key technology, design and methods areas:


10




s
            Localized
      tissue characterization using optical methods;s
            Specific
      application of fluorescence and broadband spectroscopy, and video imaging,
      particularly in combination;s
            Designs
      and use of a disposable sheath, particularly in combination with systems
      and methods, including use of unique identifiers;s
            Algorithmic
      methods specific to optical assessment of tissue characteristics,
      particularly involving identification, classification and calibration
      methods;s
            Clinical
      applications of these methods and systems for identifying tissue
      characteristics, including use of display methods, marking methods
      (including biomarkers), and in combination with treatment;
    ands
            Applications
      to further system development, including applications for screening,
      treatment and other fields beyond cervical
  cancer




SpectraScience
holds registered trademarks for the WavSTAT and LUMA Cervical Imaging System and
SpectraScience documents, software and graphics are protected by appropriate
copyrights.





SpectraScience’s
ability to obtain and maintain patent protection for its products, preserve its
trade secrets and operate without infringing on the proprietary rights of others
will directly affect the success the Company's operations. The Company's
strategy regarding the protection of its proprietary intellectual property and
innovations is to seek patents on those portions of its technology that
management believes are patentable, to obtain copyrights for its software if
appropriate, and to protect as trade secrets other confidential information and
proprietary know-how. There are certain technological aspects of the WavSTAT and
LUMA Systems that are not covered by any patents or patent applications.
SpectraScience seeks to protect its trade secrets and proprietary know-how by
obtaining confidentiality and invention assignment agreements in connection with
employment, consulting and advisory relationships.




Our
ability to obtain and maintain patent protection for our products, preserve our
trade secrets and operate without infringing on the proprietary rights of others
will directly affect how successful our operations will be. Our strategy
regarding the protection of our proprietary rights and innovations is to seek
patents on those portions of our technology that we believe are patentable, and
to protect as trade secrets other confidential information and proprietary
know-how.




The
patent and trade secret positions of medical device companies like
SpectraScience are uncertain and involve complex and evolving legal and factual
questions. To date, no claims have been brought against SpectraScience alleging
that our technology or products infringe intellectual property rights of others.
Often, patent and intellectual property disputes in the medical device industry
are settled through licensing or similar arrangements. However, there can be no
assurance that necessary licenses from other parties would be available to us on
satisfactory terms, if at all. The costs associated with such arrangements may
be substantial and could include ongoing royalties.




United
States patent applications are secret until patents are issued or corresponding
foreign applications are published in other countries. Since publication of
discoveries in the scientific or patent literature often lags behind actual
discoveries, management cannot be certain that SpectraScience was the first to
invent the inventions covered by each of its pending patent applications, or
that it was the first to file patent applications for such inventions. In
addition, the laws of some foreign countries do not provide the same degree of
intellectual property right protection as do the laws of the United States.
Litigation associated with patent or intellectual property infringement or
protection can be lengthy and prohibitively costly. There can be no assurance
that SpectraScience would have the financial resources to defend its patents
from infringement or claims of invalidity, or to successfully defend itself
against intellectual property infringement claims by third parties.




Product
Liability




The risk
of product liability claims, product recalls and associated adverse publicity is
inherent in the testing, manufacturing, marketing and sale of medical products.
We have clinical trial liability insurance coverage for our clinical programs.
There can be no assurance that future insurance coverage will be adequate or
available. We may not be able to secure product liability insurance coverage on
acceptable terms or at reasonable costs when needed. Any liability damages could
exceed the amount of our coverage. A successful product liability claim against
us could require us to pay a substantial monetary award. Moreover, a product
recall could generate substantial negative publicity about our products and
business and inhibit or prevent commercialization of other future
products.




Employees




As of
March 26, 2010, SpectraScience had eight full-time employees, five involved with
manufacturing, one in sales and marketing and two engaged in finance and
administration. The Company’s payroll is administered through an independent
third party. SpectraScience is not subject to any collective bargaining
agreement and management believes that employee relations are generally
satisfactory.




SpectraScience
relies on external consultants in the financial, regulatory, software
development and design engineering areas. When management determines to increase
our workforce in response to improved economic, market, and/or business
conditions, there is no assurance that we will be able to attract or retain
employees with the skills we require.




11




ITEM 1A.
RISK FACTORS.




We have
described below a number of uncertainties and risks which, in addition to
uncertainties and risks presented elsewhere in this annual report, may adversely
affect our business, operating results and financial condition. The
uncertainties and risks enumerated below as well as those presented elsewhere in
this annual report should be considered carefully in evaluating our company and
our business and the value of our securities.




RISKS RELATED TO OUR
BUSINESS




WE HAVE A
LIMITED OPERATING HISTORY WITH SIGNIFICANT LOSSES AND EXPECT LOSSES TO CONTINUE
FOR THE FORESEEABLE FUTURE




We have
yet to establish any history of profitable operations. We have incurred annual
operating losses of $4,436,812 and $5,271,332, respectively, during the past two
years of operations. As a result, at December 31, 2009 we had an accumulated
deficit of $18,744,470. We have incurred net losses from continuing operations
of $4,432,187 and $5,144,902 for the fiscal years ending 2009 and 2008. Our
revenues have not been sufficient to sustain our operations and we expect that
they will be insufficient to sustain our operations for the foreseeable future.
Our failure to generate meaningful revenues and ultimately profits from the
WavSTAT and LUMA Systems and applications of our technology could force us to
raise additional capital which may not be available or available on acceptable
terms. This could ultimately reduce or suspend our operations and ultimately
cause us to go out of business. Our profitability will require the successful
commercialization of our imaging systems and no assurances can be given when
this will occur or if we will ever be profitable.




WE WILL
REQUIRE ADDITIONAL FINANCING TO SUSTAIN OUR OPERATIONS AND WITHOUT IT, WE MAY
NOT BE ABLE TO CONTINUE OPERATIONS.




At
December 31, 2009, we had a working capital balance of $3,662,493. We had an
operating cash flow deficit of $2,463,180 for the fiscal year ended December 31,
2009 and an operating cash flow deficit of $3,811,212 in 2008. We may not have
sufficient financial resources to fund our operations and will likely require
additional funds to continue our operations.




The
Company has in place, but has not yet utilized, a $6.0 million Common Stock
Purchase Agreement (“Purchase Agreement”) with Fusion Capital Fund II LLC
(“Fusion Capital”). We only have the right to receive $25,000 every two business
days under the Purchase Agreement with Fusion Capital unless our stock price
equals or exceeds $0.30, in which case we can sell greater amounts to Fusion
Capital as the price of our Common Stock increases.  Fusion Capital does
not have the right nor the obligation to purchase any shares of our Common Stock
on any business day that the market price of our Common Stock is less than
$0.15. We have previously registered 13,300,000 shares for sale by Fusion
Capital pursuant to a previously filed registration statement (11,558,974 total
registered shares to be issued and sold under the Purchase Agreement, plus
100,000 expense shares, 1,094,017 initial commitment shares and 547,009
allocable commitment shares). The selling price of our Common Stock to Fusion
Capital will have to average approximately $0.52 per share for us to receive the
maximum proceeds of $6.0 million.  Assuming a purchase price of $0.36 per
share (the closing sale price of the Common Stock on March 26, 2010) and the
purchase by Fusion Capital of the full 11,558,974 shares remaining under the
Purchase Agreement, proceeds to us would only be $4,161,231 unless we choose to
register more shares which we may sell to Fusion Capital, which we have the
right, but not the obligation, to do.





The
extent to which we will rely on Fusion Capital as a source of funding will
depend on a number of factors including, the prevailing market price of our
Common Stock and the extent to which we are able to secure working capital from
other sources. If obtaining additional financing from Fusion Capital were to
prove unavailable or prohibitively dilutive and if we are unable to
commercialize and sell enough of our products, we will likely need to secure
another source of funding in order to satisfy our working capital needs. 
Even if we are able to access the full $6.0 million under the Purchase Agreement
with Fusion Capital, we may still need additional capital to fully implement our
business, operating and development plans.  Should the financing we require
to sustain our working capital needs be unavailable or prohibitively expensive
when we require it, the consequences could have a material adverse effect on our
business, operating results, financial condition and prospects.




WE MAY
FACE INTENSE COMPETITION FROM COMPANIES THAT HAVE GREATER FINANCIAL, PERSONNEL
AND RESEARCH AND DEVELOPMENT RESOURCES.





Competitive
forces may impact our projected growth and ability to generate revenues and
profits, which would have a negative impact on our business and the value of
your investment. Our competitors may be developing products that compete with
the WavSTAT and LUMA Systems. Our commercial opportunities would then be reduced
or eliminated should our competitors develop and market products for any of the
diseases that we target that are more effective or are less expensive than the
products or product candidates we are developing.





Even if
we are successful in developing effective WavSTAT and LUMA Systems, and we
obtain FDA and other regulatory approvals necessary for commercializing them,
our products may not compete effectively with other successful products.
Researchers are continually learning more about diseases, which may lead to new
technologies and tools for analysis.


12





Our
competitors include fully integrated medical device companies, universities and
public and private research institutions. Many of the organizations competing
with us may have substantially greater capital resources, larger research and
development staffs and facilities, greater experience in product development and
in obtaining regulatory approvals, and greater marketing capabilities than we
do.





The
market for medical devices is intensely competitive. Many of our potential
competitors have longer operating histories, greater name recognition, more
employees, and significantly greater financial, technical, marketing, public
relations, and distribution resources than we have. This intense competitive
environment may require us to make changes in our products, pricing, licensing,
services or marketing to develop, maintain and extend our current technology.
Price concessions or the emergence of other pricing or distribution strategies
of competitors may diminish our revenues, adversely impact our margins or lead
to a reduction in our market share, any of which may harm our
business.




OUR
WavSTAT AND LUMA SYSTEMS TECHNOLOGY MAY BECOME OBSOLETE.




Our
WavSTAT and LUMA Systems products may be made unmarketable by new scientific or
technological developments where new treatment modalities are introduced that
are more efficacious or more economical than our WavSTAT and LUMA System
products. Any one of our competitors could develop a more effective product
which would render our technology obsolete.




WE ARE
DEPENDENT FOR OUR SUCCESS ON A KEY EXECUTIVE OFFICER.




Our
success depends to a critical extent on the continued services of our Chief
Executive Officer, Jim Hitchin. If we lost this key executive officer, we would
be forced to expend significant time and money in the pursuit of a replacement,
which would result in both a delay in the implementation of our business plan
and the diversion of limited working capital. We can give you no assurance that
we could find a satisfactory replacement for this key executive officer at all,
or on terms that are not unduly expensive or burdensome. We do not have an
employment agreement with Mr. Hitchin and his employment is severable by either
party at will.




OUR INABILITY TO ATTRACT AND RETAIN
QUALIFIED PERSONNEL COULD IMPEDE OUR ABILITY TO GENERATE REVENUES AND PROFITS
AND TO OTHERWISE IMPLEMENT OUR BUSINESS PLAN AND GROWTH STRATEGIES, WHICH WOULD
HAVE A NEGATIVE IMPACT ON OUR BUSINESS AND COULD ADVERSELY AFFECT THE VALUE OF
YOUR INVESTMENT.





We
currently have a staff of eight full time employees, consisting of, among
others, our Chief Executive Officer, Chief Financial Officer, Director of Sales
and Marketing, Operations Manager and a Chief Engineer Director as well as
administrative employees and other personnel employed on a contract basis.
Although we believe that these employees, together with the consultants
currently engaged by the Company, will be able to handle most of our additional
administrative, research and development and business development in the near
term, we will nevertheless be required over the longer-term to hire highly
skilled managerial, scientific and administrative personnel to fully implement
our business plan and growth strategies. We cannot assure you that we will be
able to engage the services of such qualified personnel at competitive prices or
at all, particularly given the risks of employment attributable to our limited
financial resources and lack of an established track record.




WE PLAN
TO GROW VERY RAPIDLY, WHICH WILL PLACE STRAINS ON OUR MANAGEMENT TEAM AND OTHER
COMPANY RESOURCES TO BOTH IMPLEMENT MORE SOPHISTICATED MANAGERIAL, OPERATIONAL
AND FINANCIAL SYSTEMS, PROCEDURES AND CONTROLS AND TO TRAIN AND MANAGE THE
PERSONNEL NECESSARY TO IMPLEMENT THOSE FUNCTIONS. OUR INABILITY TO MANAGE OUR
GROWTH COULD IMPEDE OUR ABILITY TO GENERATE REVENUES AND PROFITS AND TO
OTHERWISE IMPLEMENT OUR BUSINESS PLAN AND GROWTH STRATEGIES, WHICH WOULD HAVE A
NEGATIVE IMPACT ON OUR BUSINESS AND THE VALUE OF YOUR INVESTMENT.




We will
need to significantly expand our operations to implement our longer-term
business plan and growth strategies. We will also be required to manage multiple
relationships with various strategic partners, technology licensors, customers,
manufacturers and suppliers, consultants and other third parties. This expansion
and these expanded relationships will require us to significantly improve or
replace our existing managerial, operational and financial systems, procedures
and controls; to improve the coordination between our various corporate
functions; and to manage, train, motivate and maintain a growing employee base.
The time and costs to effectuate these steps may place a significant strain on
our management personnel, systems and resources, particularly given the limited
amount of financial resources and skilled employees that may be available at the
time. We cannot assure you that we will institute, in a timely manner or at all,
the improvements to our managerial, operational and financial systems,
procedures and controls necessary to support our anticipated increased levels of
operations and to coordinate our various corporate functions, or that we will be
able to properly manage, train, motivate and retain the anticipated increased
number of employees.




WE MAY
HAVE DIFFICULTY IN DEVELOPING AND RETAINING AN EFFECTIVE SALES FORCE OR IN
OBTAINING EFFECTIVE DISTRIBUTION PARTNERS AND MAY NOT BE ABLE TO ACHIEVE
SUFFICIENT REVENUES TO EFFECT OUR BUSINESS PLAN




The
market for skilled sales and marketing personnel is highly competitive and
specialized. If we are unable to hire and retain skilled and knowledgeable sales
people it may negatively impact our ability to introduce our products or
generate revenue sufficient to affect our future business plans. In addition,
our inability to develop business relationships with key technical distributors
may also negatively impact our ability to successfully market our
products.


13




THE
COMPANY MAY BE UNSUCCESSFUL IN COMMERCIALIZING THE LUMA ASSETS




With the
successful acquisition of the LUMA Imaging Corporation’s stock in November of
2007, we will have to manage its assets, primarily intellectual property, to
successfully commercialize the LUMA products. Our limited number of technical
and marketing personnel, and our limited budget, may be inadequate for
successful market development.




WE MAY
HAVE DIFFICULTY IN ATTRACTING AND RETAINING MANAGEMENT AND OUTSIDE INDEPENDENT
MEMBERS TO OUR BOARD OF DIRECTORS AS A RESULT OF THEIR CONCERNS RELATING TO
THEIR INCREASED PERSONAL EXPOSURE TO LAWSUITS AND SHAREHOLDER CLAIMS BY VIRTUE
OF HOLDING THESE POSITIONS IN A PUBLICLY-HELD COMPANY.





The directors and management of
publicly traded corporations are increasingly concerned with the extent of their
personal exposure to lawsuits and shareholder claims, as well as governmental
and creditor claims which may be made against them, particularly in view of
recent changes in securities laws imposing additional duties, obligations and
liabilities on management and directors. Due to these perceived risks, directors
and management are also becoming increasingly concerned with the availability of
directors and officers liability insurance to pay on a timely basis the costs
incurred in defending such claims. We currently carry directors and officers
liability insurance, but such insurance is expensive and can be difficult to
obtain. If we are unable to obtain directors and officers liability insurance at
affordable rates or at all in the future, it may become increasingly more
difficult to attract and retain qualified outside directors to serve on our
board of directors. The fees of directors are also rising in response to their
increased duties, obligations and liabilities as well as increased exposure to
such risks. As a company with a limited operating history and limited resources,
we will have a more difficult time attracting and retaining management and
outside independent directors than a more established company due to these
enhanced duties, obligations and liabilities.





IF WE
FAIL TO COMPLY WITH EXTENSIVE REGULATIONS ENFORCED BY DOMESTIC AND FOREIGN
REGULATORY AUTHORITIES, THE COMMERCIALIZATION OF OUR PRODUCTS COULD BE PREVENTED
OR DELAYED.





Our
WavSTAT and LUMA Systems are subject to extensive government regulations related
to development, testing, manufacturing and commercialization in the United
States and other countries. The determination of when and whether a product is
ready for large scale purchase and potential use will be made by the government
through consultation with a number of governmental agencies, including the FDA,
the National Institutes of Health, and the Centers for Disease Control and
Prevention. Some of our product candidates are in the clinical stages of
development and have not received required regulatory approval from the FDA for
the esophageal or lung applications we hope to commercially market. The process
of obtaining and complying with the FDA and other governmental regulatory
approvals and regulations is costly, time consuming, uncertain and subject to
unanticipated delays. Despite the time and expense incurred, regulatory approval
is never guaranteed. We also are subject to the following risks and obligations,
among others:





·
            The
      FDA may refuse to approve an application if they believe that applicable
      regulatory criteria are not
satisfied;





·
            The
      FDA may require additional testing for safety and
      effectiveness;





·
            The
      FDA may interpret data from pre-clinical testing and clinical trials in
      different ways than us;





·
            If
      regulatory approval of a product is granted, the approval may be limited
      to specific indications or limited with respect to its distribution;
      and





·
            The
      FDA may change their approval policies and/or adopt new
      regulations





Failure
to comply with these or other regulatory requirements of the FDA may subject us
to administrative or judicially imposed sanctions, including:





·
            Warning
      letters;





·
            Civil
      penalties;





·
            Criminal
      penalties;





·
            Injunctions;





·
            Product
      seizure or detention;





·
            Product
      recalls; and




14




·
            Total
      or partial suspension of production





DELAYS IN
SUCCESSFULLY COMPLETING OUR CLINICAL TRIALS COULD JEOPARDIZE OUR ABILITY TO
OBTAIN REGULATORY APPROVAL OR MARKET OUR WavSTAT AND LUMA SYSTEM CANDIDATES ON A
TIMELY BASIS.





Our
business prospects will depend on our ability to complete clinical trials,
obtain satisfactory results, obtain required regulatory approvals and
successfully commercialize our WavSTAT and LUMA System product candidates.
Completion of our clinical trials, announcement of results of the trials and our
ability to obtain regulatory approvals could be delayed for a variety of
reasons, including:





·
            Unsatisfactory
      results of any clinical trial;





·
            The
      failure of principal third-party investigators to perform clinical trials
      on our anticipated schedules; and





·
            Different
      interpretations of pre-clinical and clinical data, which could initially
      lead to inconclusive results





OUR DEVELOPMENT COSTS WILL INCREASE IF
WE HAVE MATERIAL DELAYS IN ANY CLINICAL TRIAL OR IF WE NEED TO PERFORM MORE OR
LARGER CLINICAL TRIALS THAN PLANNED.





If
clinical trial delays are significant, or if any of our WavSTAT System or LUMA
product candidates do not prove to be safe or effective or do not receive
required regulatory approvals, our financial results and the commercial
prospects for our product candidates will be harmed. Furthermore, our inability
to complete our clinical trials in a timely manner could jeopardize our ability
to obtain regulatory approval.





THE
INDEPENDENT CLINICAL INVESTIGATORS THAT WE RELY UPON TO CONDUCT OUR CLINICAL
TRIALS MAY NOT BE DILIGENT, CAREFUL OR TIMELY, AND MAY MAKE MISTAKES, IN THE
CONDUCT OF OUR CLINICAL TRIALS.





We depend
on independent clinical investigators to conduct our clinical trials. The
investigators are not our employees, and we cannot control the amount or timing
of resources that they devote to our product development programs. If
independent investigators fail to devote sufficient time and resources to our
product development programs, or if their performance is substandard, it may
delay FDA approval of our products. These independent investigators may also
have relationships with other commercial entities, some of which may compete
with us. If these independent investigators assist our competitors at our
expense, it could harm our competitive position.





OUR
PRODUCT DEVELOPMENT EFFORTS MAY NOT YIELD MARKETABLE PRODUCTS DUE TO RESULTS OF
STUDIES OR TRIALS, FAILURE TO ACHIEVE REGULATORY APPROVALS OR MARKET ACCEPTANCE,
PROPRIETARY RIGHTS OF OTHERS OR MANUFACTURING ISSUES.





Our
success depends on our ability to successfully develop and obtain regulatory
approval to market new products. We expect that a significant portion of the
research that we will conduct will involve new and unproven technologies.
Development of a product requires substantial technical, financial and human
resources even if the product is not successfully completed.





Potential
products may appear to be promising at various stages of development yet fail to
reach the market for a number of reasons, including the:





·
            Lack
      of adequate quality or sufficient prevention benefit, or unacceptable
      safety during pre-clinical studies or clinical
  trials;




·
            Failure
      to receive necessary regulatory
approvals;





·
            Existence
      of proprietary rights of third parties;
and/or





·
            Inability
      to develop manufacturing methods that are efficient, cost-effective and
      capable of meeting stringent regulatory
  standards




OUR
INABILITY TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS COULD NEGATIVELY IMPACT
OUR PROJECTED GROWTH AND ABILITY TO GENERATE REVENUES AND PROFITS, WHICH WOULD
HAVE A NEGATIVE IMPACT ON OUR BUSINESS AND THE VALUE OF YOUR
INVESTMENT.




15




We rely
on a combination of patent, patent pending, copyright, trademark and trade
secret laws, proprietary rights agreements and non-disclosure agreements to
protect our intellectual properties. We cannot give you any assurance that these
measures will prove to be effective in protecting our intellectual
properties.





In the
case of patents, we cannot give you any assurance that our existing patents will
not be invalidated, that any patents that we currently or prospectively apply
for will be granted, or that any of these patents will ultimately provide
significant commercial benefits. Further, competing companies may circumvent any
patents that we may hold by developing products which closely emulate but do not
infringe our patents. While we currently have and intend to seek patent
protection for our products in selected foreign countries, those patents may not
receive the same degree of protection as they would in the United States. We can
give you no assurance that we will be able to successfully defend our patents
and proprietary rights in any action we may file for patent infringement.
Similarly, we cannot give you any assurance that we will not be required to
defend against litigation involving the patents or proprietary rights of others,
or that we will be able to obtain licenses for these rights. Legal and
accounting costs relating to prosecuting or defending patent infringement
litigation may be substantial.





The
WavSTAT System is protected by eight issued patents, in the United States,
Canada, Europe and Japan, which we own, and one additional patent for which we
own the exclusive license. In October 2006, the Company filed for a patent
entitled “System and Method for Non-Endoscopic Optical Biopsy Detection of
Diseased Tissue.” Our LUMA system is the subject of 52 patent applications
worldwide, 38 of which have issued and 18 patents are pending.





We also rely on proprietary designs,
technologies, processes and know-how not eligible for patent protection. We
cannot give you any assurance that our competitors will not independently
develop the same or superior designs, technologies, processes and
know-how.





While we
have and will continue to enter into proprietary rights agreements with our
employees and third parties giving us proprietary rights to certain technology
developed by those employees or parties while engaged by the Company, we can
give you no assurance that courts of competent jurisdiction will enforce those
agreements.




THE
PATENTS WE OWN COMPRISE A LARGE PORTION OF OUR ASSETS, WHICH COULD LIMIT OUR
FINANCIAL VIABILITY.




The
WavSTAT System is protected by eight issued patents, in the United States,
Canada, Europe and Japan, and an additional patent for which we own an exclusive
license. One of the eight patents has lapsed for failure to pay maintenance
fees, and we are in the process of reinstating the patent. We cannot assure you
that we will be successful in reinstating the patent. In addition, our LUMA
System is the subject of 52 patent applications worldwide, 38 of which have been
issued with 18 patents pending. These patents comprise approximately 36% of our
assets at December 31, 2009. If our existing patents are invalidated or if they
fail to provide significant commercial benefits, it will severely hurt our
financial condition, as a significant percentage of our assets would lose their
value. Further, since our patents are amortized over the course of their term
until they expire, our assets comprised of patents will continually be written
down until they lose value altogether.




LEGISLATIVE
ACTIONS AND POTENTIAL NEW ACCOUNTING PRONOUNCEMENTS ARE LIKELY TO IMPACT OUR
FUTURE FINANCIAL POSITION AND RESULTS OF OPERATIONS.





Compliance
with publicly-traded company regulations adversely impacts our resources. As a
publicly-traded company, we are subject to rules and regulations that increase
our legal and financial compliance costs, make some activities more
time-consuming and costly, and divert our management's attention away from the
operation of our business. We are obligated to file with the U.S. Securities and
Exchange Commission, or the SEC, annual and quarterly information and other
reports that are specified in the Securities Exchange Act of 1934, or the
Exchange Act, and are also subject to other reporting and corporate governance
requirements, including requirements of the Sarbanes-Oxley Act of 2002, and the
rules and regulations promulgated thereunder, which impose significant
compliance and reporting obligations upon us.  We may not be
successful in complying with these obligations, and compliance with these
obligations could be time consuming and expensive. Failure to comply with the
additional reporting and corporate governance requirements could lead to fines
imposed on us, deregistration under the Exchange Act and, in the most egregious
cases, criminal sanctions could be imposed.




OUR
PRODUCTS MAY BE SUBJECT TO RECALL OR PRODUCT LIABILITY CLAIMS.




Our
WavSTAT and LUMA System products may be used in connection with medical
procedures in which it is important that those products function with precision
and accuracy. If our products do not function as designed, or are designed
improperly, we may be forced by regulatory agencies to withdraw such products
from the market. In addition, if medical personnel or their patients suffer
injury as a result of any failure of our products to function as designed, or an
inappropriate design, we may be subject to lawsuits seeking significant
compensatory and punitive damages. Any product recall or lawsuit seeking
significant monetary damages may have a material effect on our business and
financial condition.




WE HAVE
NOT PAID ANY CASH DIVIDENDS AND NO CASH DIVIDENDS WILL BE PAID IN THE
FORESEEABLE FUTURE.




We do not
anticipate paying cash dividends on our Common Stock in the foreseeable future,
and we cannot assure an investor that funds will be legally available to pay
dividends or that even if the funds are legally available, that the dividends
will be paid.


16




RISKS
RELATED TO OUR CAPITAL STOCK




THE
APPLICATION OF THE "PENNY STOCK" RULES COULD ADVERSELY AFFECT THE MARKET PRICE
OF OUR COMMON STOCK AND INCREASE YOUR TRANSACTION COSTS TO SELL YOUR
STOCK.





As long
as the trading price of our Common Stock is below $5 per share, the open-market
trading of our Common Stock will be subject to the “penny stock” rules. The
“penny stock” rules impose additional sales practice requirements on
broker-dealers who sell securities to persons other than established customers
and accredited investors (generally those with assets in excess of $1,000,000 or
annual income exceeding $200,000 or $300,000 together with their spouse). For
transactions covered by these rules, the broker-dealer must make a special
suitability determination for the purchase of securities and have received the
purchaser’s written consent to the transaction before the purchase.
Additionally, for any transaction involving a penny stock, unless exempt, the
broker-dealer must deliver, before the transaction, a disclosure schedule
prescribed by the SEC relating to the penny stock market. The broker-dealer also
must disclose the commissions payable to both the broker-dealer and the
registered representative and current quotations for the securities. Finally,
monthly statements must be sent disclosing recent price information on the
limited market in penny stocks. These additional burdens imposed on
broker-dealers may restrict the ability or decrease the willingness of
broker-dealers to sell our Common Stock, and may result in decreased liquidity
for our Common Stock and increased transaction costs for sales and purchases of
our Common Stock as compared to other securities.




OUR
COMMON STOCK IS THINLY TRADED, SO INVESTORS MAY BE UNABLE TO SELL AT OR NEAR ASK
PRICES OR AT ALL.





Our Common Stock has historically been
sporadically or “thinly-traded”, meaning that the number of persons interested
in purchasing our Common Stock at or near ask prices at any given time may be
relatively small or non-existent. As of March26, 2010, our average trading volume per
day for the past three months was approximately99,000shares a day with a high of502,600shares traded and a low of700shares traded per day. This situation
is attributable to a numberof factors, including the fact that we
are a small company which is relatively unknown to stock analysts, stock
brokers, institutional investors and others in the investment community that
generate or influence sales volume, and that even if we came to the attention of
such persons, they tend to be risk-averse and would be reluctant to follow an
unproven company such as ours or purchase or recommend the purchase of our
shares until such time as we became more seasoned and viable. As a consequence,
there may be periods of several days or more when trading activity in our shares
is minimal or non-existent, as compared to a seasoned issuer which has a large
and steady volume of trading activity that will generally support continuous
sales without an adverse effect on share price. We cannot give you any assurance
that a broader or more active public trading market for our Common Stock will
develop or be sustained, or that current trading levels will be
sustained.





THE
MARKET PRICE FOR OUR COMMON STOCK IS PARTICULARLY VOLATILE, GIVEN OUR STATUS AS
A RELATIVELY UNKNOWN COMPANY WITH A SMALL AND THINLY-TRADED PUBLIC FLOAT,
LIMITED OPERATING HISTORY AND LACK OF REVENUES WHICH COULD LEAD TO WIDE
FLUCTUATIONS IN OUR SHARE PRICE.





The
market for our Common Stock is characterized by significant price volatility
when compared to seasoned issuers, and we expect that our share price will
continue to be more volatile than a seasoned issuer for the foreseeable future.
In fact, during the ninety-day period ended March 26, 2010, the high and low
closing prices of a share of our Common Stock were $0.46 and $0.29,
respectively. The volatility in our share price is attributable to a number of
factors. First, as noted above, our stock is sporadically and/or thinly-traded.
As a consequence of this lack of liquidity, the trading of relatively small
quantities of shares by our shareholders may disproportionately influence the
price of those shares in either direction. The price for our shares could, for
example, decline precipitously in the event that a large number of our shares
are sold on the market without commensurate demand, as compared to a seasoned
issuer which could better absorb those sales without adverse impact on its share
price. Secondly, we are a speculative or “risky” investment due to our limited
operating history and lack of revenues or profits to date and uncertainty of
future market acceptance for our potential products. As a consequence of this
enhanced risk, more risk-adverse investors may, under the fear of losing all or
most of their investment in the event of negative news or lack of progress, be
more inclined to sell their shares on the market more quickly and at greater
discounts than would be the case with the stock of a seasoned issuer. The
following factors may add to the volatility in the price of our Common Stock:
actual or anticipated variations in our quarterly or annual operating results;
acceptance of our proprietary technology; government regulations, announcements
of significant acquisitions, strategic partnerships or joint ventures; our
capital commitments; and additions or departures of our key personnel. Many of
these factors are beyond our control and may decrease the market price of our
Common Stock, regardless of our operating performance. We cannot make any
predictions or projections as to what the prevailing market price for our Common
Stock will be at any time, including as to whether our Common Stock will sustain
its current market prices, or as to what effect that the sale of shares or the
availability of Common Stock for sale at any time will have on the prevailing
market price.




17


THE
MARKET FOR PENNY STOCKS SUCH AS OURS HAS BEEN SUBJECT TO FRAUD AND ABUSE AND MAY
CAUSE OUR STOCK PRICE TO BE MORE VOLATILE.





Shareholders
should be aware that, according to SEC Release No. 34-29093, the market for
penny stocks has suffered in recent years from patterns of fraud and abuse. Such
patterns include (1) control of the market for the security by one or a few
broker-dealers that are often related to the promoter or issuer; (2)
manipulation of prices through prearranged matching of purchases and sales and
false and misleading press releases; (3) boiler room practices involving
high-pressure sales tactics and unrealistic price projections by inexperienced
sales persons; (4) excessive and undisclosed bid-ask differential and markups by
selling broker-dealers; and (5) the wholesale dumping of the same securities by
promoters and broker-dealers after prices have been manipulated to a desired
level, along with the resulting inevitable collapse of those prices and
consequent investor losses. Our management is aware of the abuses that have
occurred historically in the penny stock market. Although we do not expect to be
in a position to dictate the behavior of the market or of broker-dealers who
participate in the market, management will strive within the confines of
practical limitations to prevent the described patterns from being established
with respect to our securities. The occurrence of these patterns or practices
could increase the volatility of our share price. In addition, potential
dilutive effects of future sales of shares of Common Stock by shareholders and
by the Company could have an adverse effect on the market price of our
shares.





VOLATILITY
IN OUR COMMON STOCK PRICE MAY SUBJECT US TO SECURITIES LITIGATION.





The
market for our Common Stock is characterized by significant price volatility
when compared to seasoned issuers, and we expect that our share price will
continue to be more volatile than a seasoned issuer for the indefinite future.
In the past, plaintiffs have sometimes initiated securities class action
litigation against a company following periods of volatility in the market price
of its securities. We may in the future be the target of similar litigation.
Securities litigation could result in substantial costs and liabilities and
could divert management's attention and resources.





OUR
OFFICERS AND DIRECTORS OWN OR CONTROL APPROXIMATELY 12% (INCLUDING ALL OPTIONS
EXERCISABLE WITHIN 60 DAYS OF MARCH 26, 2010) OF OUR OUTSTANDING COMMON STOCK,
WHICH MAY LIMIT THE ABILITY OF OTHER SHAREHOLDERS, WHETHER ACTING SINGLY OR
TOGETHER, TO PROPOSE OR DIRECT THE MANAGEMENT OR OVERALL DIRECTION OF THE
COMPANY.





As of
March 26, 2010, our officers and directors beneficially own or control
approximately 12% (including all options exercisable within sixty days of March
26, 2010) of our outstanding Common Stock. These persons will have the ability
to control substantially all matters submitted to our shareholders for approval
and to control our management and affairs, including extraordinary transactions
such as mergers and other changes of corporate control, and going private
transactions which could discourage or prevent a potential takeover of the
Company that might otherwise result in shareholders receiving a premium over the
market price of their common stock.




A LARGE
NUMBER OF SHARES OF COMMON STOCK ARE ISSUABLE UPON EXERCISE OF OUTSTANDING
OPTIONS. THE EXERCISE OF THESE SECURITIES COULD RESULT IN THE SUBSTANTIAL
DILUTION OF THE INVESTMENT OF OTHER SHAREHOLDERS IN TERMS OF PERCENTAGE
OWNERSHIP IN THE COMPANY AS WELL AS THE BOOK VALUE OF THE COMMON STOCK. THE SALE
OF A LARGE AMOUNT OF COMMON STOCK RECEIVED UPON EXERCISE OF THESE OPTIONS ON THE
PUBLIC MARKET TO FINANCE THE EXERCISE PRICE OR TO PAY ASSOCIATED INCOME TAXES,
OR THE PERCEPTION THAT SUCH SALES COULD OCCUR, COULD SUBSTANTIALLY DEPRESS THE
PREVAILING MARKET PRICES FOR OUR STOCK.





As of
March 26, 2010, there are outstanding Common Stock purchase options entitling
the holders to purchase 7,450,000 shares of Common Stock at a weighted average
exercise price of $0.54 per share (5,050,000 of these shares are
exercisable within 60 days of March 26, 2010). The exercise price for all of the
options may be less than your cost to acquire our Common Stock. In the event of
the exercise or conversion of these securities, you could suffer substantial
dilution of your investment in terms of your percentage ownership in the company
as well as the book value of your Common Stock. In addition, the holders of the
common stock purchase options may sell Common Stock in tandem with their
exercise of those options to finance that exercise, or may resell the shares
purchased in order to cover any income tax liabilities that may arise from their
exercise of the options, which could substantially depress the prevailing market
price of our stock.




OUR
ISSUANCE OF ADDITIONAL COMMON STOCK, OR OPTIONS TO PURCHASE OUR COMMON STOCK,
WOULD DILUTE YOUR PROPORTIONATE OWNERSHIP AND VOTING RIGHTS.





We are
entitled under our articles of incorporation to issue up to 225,000,000 shares
of capital stock which includes 160,000,000 shares of Common Stock, 25,000,000
shares of Preferred Stock and 40,000,000 undesignated shares. Our undesignated
shares may be designated as in a senior position to our Common Stock. After
taking into consideration our outstanding Common Stock at March 26, 2010, we
will be entitled to issue up to 26,087,831 additional shares of Common Stock
(160,000,000 authorized less shares outstanding of 89,912,615, 5,335,000 shares
for issuance upon conversion of Preferred Stock, 11,558,974 additional shares
reserved for issuance to Fusion Capital, 10,521,392 shares reserved for issuance
of stock options, 12,500,000 shares reserved for issuance of Common
Stock purchase warrants 3,287,966 shares reserved for placement agent warrants,
547,009 allocable commitment fee shares and 249,213 shares of Common Stock
issued for payment of cumulative preferred dividends) and up to 40,000,000
shares of undesignated capital stock. Our board of directors may generally issue
stock, or options or warrants to purchase those shares, without further approval
by our shareholders based upon such factors as our board of directors may deem
relevant at that time. It is likely that we will be required to issue a large
amount of additional securities to raise capital to further our development. It
is also likely that we will be required to issue a large amount of additional
securities to directors, officers, employees and consultants as compensatory
grants in connection with their services, both in the form of stand-alone grants
or under our stock plans. We cannot give you any assurance that we will not
issue additional shares of Common Stock, or options or warrants to purchase
those shares, under circumstances we may deem appropriate at the
time.


18




THE
LIMITATION OF MONETARY LIABILITY OF OUR DIRECTORS, OFFICERS AND EMPLOYEES UNDER
OUR ARTICLES OF INCORPORATION AND THE INDEMNIFICATION RIGHTS OF OUR DIRECTORS,
OFFICERS, CONSULTANTS AND EMPLOYEES MAY RESULT IN SUBSTANTIAL EXPENDITURES BY US
AND MAY DISCOURAGE LAWSUITS AGAINST OUR DIRECTORS, OFFICERS, CONSULTANTS AND
EMPLOYEES.




Our
articles of incorporation contain provisions which eliminate the liability of
our directors and officers for monetary damages to the Company and shareholders.
Our bylaws also require us to indemnify our officers and directors. We may also
have contractual indemnification obligations under our agreements with our
directors, officers, consultants and employees. The foregoing indemnification
obligations could result in our company incurring substantial expenditures to
cover the cost of settlement or damage awards against directors, officers,
consultants and employees, which we may be unable to recoup. These provisions
and resultant costs may also discourage us from bringing a lawsuit against
directors, officers, consultants and employees for breaches of their fiduciary
duties, and may similarly discourage the filing of derivative litigation by our
shareholders against our directors, officers, consultants and employees even
though such actions, if successful, might otherwise benefit the Company and
shareholders.




ANTI-TAKEOVER
PROVISIONS MAY IMPEDE THE ACQUISITION OF OUR COMPANY.




Certain
provisions of the Minnesota Business Corporation Act and other Minnesota laws
have anti-takeover effects and may inhibit a non-negotiated merger or other
business combination. These provisions are intended to encourage any person
interested in acquiring us to negotiate with, and to obtain the approval of, our
Board of Directors in connection with such a transaction. However, certain of
these provisions may discourage a future acquisition of the Company, including
an acquisition in which the shareholders might otherwise receive a premium for
their shares. As a result, shareholders who might desire to participate in such
a transaction may not have the opportunity to do so.





ITEM 1B.
UNRESOLVED STAFF COMMENTS.





None





ITEM 2.
PROPERTIES.





SpectraScience
leases its principal facility from an unrelated third party. The facility is
located at 11568-11 Sorrento Valley Road, San Diego, California 92121, and is
well maintained and approved by the FDA for manufacturing. The facility consists
of approximately 5,080 square feet of office, research and development,
manufacturing, quality testing, and warehouse space. The lease provides for
monthly rental payments of $4,318 through December 2011, plus a pro rata share
of operating expense and real estate taxes (approximately $972 per month). In
the event of the termination of this lease, we believe that we could lease other
acceptable space on a comparable basis.





ITEM 3.
LEGAL PROCEEDINGS.





We are
not currently a party to any legal proceedings.





ITEM 4.
(REMOVED AND RESERVED)




19




PART
II





ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS AND ISSUER
PURCHASES OF EQUITY SECURITIES





Market
Information





Our
Common Stock is quoted on the OTCBB under the symbol SCIE.OB. The last reported
bid price of the Common Stock on March 26, 2010 was $0.36.





The
following table sets forth for the calendar period indicated; the quarterly high
and low bid prices of our Common Stock as reported by the OTCBB. The prices
represent quotations between dealers, without adjustment for retail markup,
markdown or commission, and do not necessarily represent actual
transactions.





BID
      PRICEPERIOD
                  
                  HIGH
                  
                  
                  LOW2009:Fourth
      Quarter
                  
                  $
                  0.50
                  
                  
                  $
                  0.31Third
      Quarter
                  
                  
                  1.77
                  
                  
                  
                  0.25Second
      Quarter
                  
                  
                  0.75
                  
                  
                  
                  0.18First
      Quarter
                  
                  
                  0.35
                  
                  
                  
                  0.152008:Fourth
      Quarter
                  
                  $
                  0.50
                  
                  
                  $
                  0.20Third
      Quarter
                  
                  
                  0.68
                  
                  
                  
                  0.35Second
      Quarter
                  
                  
                  1.01
                  
                  
                  
                  0.61First
      Quarter
                  
                  
                  1.05
                  
                  
                  
                  0.70





On March
26, 2010 we had approximately 850 registered shareholders of record of the
89,912,615 shares of our common stock.





To date,
we have not declared or paid cash dividends on our common stock. The current
policy of the Board of Directors is to retain any earnings to fund the
development and growth of our business. Any future determination to pay cash
dividends will be at the discretion of our Board of Directors, and will be
dependent upon our financial condition, results of operations, capital
requirements and other factors our board may deem relevant at the time.Our Series B Convertible
Preferred Stock accrues an 8% dividend which ranks senior to any dividend which
would be paid on our Common Stock. No dividend or distribution can be paid or
accrued unless all accrued dividends in Series B Convertible Preferred Stock are
paid in full.




Recent Sales of Unregistered
Securities




Fiscal
Year Ended December 31, 2009




Common
Stock




In
December 2009, the Company issued 35,000 restricted shares of Common Stock to a
vendor for services. The fair value of the shares was determined to be $11,200,
and the Company recognized expense in the amount of $11,200, based upon the
market value of the stock on the date of issuance. This transaction was deemed
to be exempt from the registration requirements of the Securities Act of 1933
pursuant to Regulation D promulgated under the Securities Act of
1933.





On
January 30, 2009, we entered into a Common Stock Purchase Agreement (the
“Purchase Agreement”) with Fusion Capital Fund II, LLC, an Illinois limited
liability company. Under the Purchase Agreement, Fusion Capital is obligated,
under certain conditions, to purchase shares from us in an aggregate amount of
$6.0 million from time to time over a twenty-four (24) month
period.  Under the terms of the Purchase Agreement, on the date we
entered into the agreement, we issued Fusion Capital a commitment fee consisting
of 1,094,017 restricted shares of our common stock. The fair value of the shares
was determined to be $273,504 based upon the market value of the stock on the
date of issuance. The Company recognized non-cash amortization expense of
$141,263 for the fiscal year ended December 31, 2009 related to this issuance.
This transaction was deemed to be exempt from the registration requirements of
the Securities Act of 1933 pursuant to Regulation D promulgated under the
Securities Act of 1933.


20




Series
B Convertible Preferred Stock and Warrants





On June
22, 2009, the Board of Directors designated 25,000,000 of the Company’s
undesignated capital stock as Series B Convertible Preferred Stock (the
“Preferred”) with par value of $0.01 per share. The Preferred is convertible
into an equal number of shares of the Company’s Common Stock based upon an
initial conversion price of $0.20 per share and carries a liquidation preference
of like amount plus declared but unpaid cumulative dividends. The Preferred is
entitled to receive cumulative dividends in preference to any dividend which may
be declared on the Common Stock at the rate of 8% of the original issue price.
In addition, the Preferred has rights which provide for (i) dividend payments
senior to those with respect to common shares, (ii) voting rights equal to the
number of common shares into which the Preferred is convertible and (iii)
adjustments to the conversion price in the event of stock dividends, stock
splits or other effective stock subdivisions. The Preferred is subject to
automatic conversion in the event of (a) an underwritten public offering
exceeding $10 million in gross proceeds to the Company or, (b) the approval of
67% of the Preferred holders or (c) the underlying conversion shares becoming
freely tradable and the average daily trading volume of the underlying stock
being not less than 50,000, nor the average closing price of the underlying
stock being not less than the conversion price then in effect for 10 consecutive
trading days.





From May
through December 31, 2009, as a part of a Units offering, the Company sold
25,000,000 shares of its Preferred to accredited investors for an aggregate
consideration of $5,000,000. The Company received net cash proceeds of
$4,308,446 after the payment of finders’ fees and expenses of $691,554. In
addition, the Company issued five-year warrants to purchase 12,500,000
additional shares of Common Stock at an initial exercise price of $0.30 per
share and 2,500,000 agent warrants at an initial exercise price of $0.35 per
share. The convertible feature of the Preferred and the terms of the warrants
provide for a rate of conversion or exercise that was below market value at
issuance. Such feature, as it specifically relates to the convertible feature of
the Preferred, is characterized as a “Beneficial Conversion Feature” (“BCF”).
Pursuant to existing accounting standards, the estimated relative fair values of
the BCF and the warrants, in approximate amounts of $2,592,000 and $2,349,000,
respectively, were calculated. The value of the BCF was determined utilizing an
intrinsic value method with the fair value of the warrants determined using the
Black-Scholes option-pricing model at the date of issuance. The warrant fair
values were determined assuming a five-year term, stock volatility of between
approximately 125% and 122% and risk-free interest rates of between 1.98% and
2.74%. The stand-alone fair value of the BCF was then determined to be higher
than the remaining proceeds received and, accordingly, the value assigned to the
BCF was limited to the gross proceeds received from the offering net of the fair
value of the warrants. Per the guidance of accounting standards, the value of
the BCF is treated as a deemed dividend to the Preferred stockholders and, due
to the potential immediate convertibility of the Preferred stock at issuance,
this value is recorded as an increase to both additional-paid-in-capital and
accumulated deficit at the time of issuance. Our Series B Convertible Preferred
Stock accrues an 8% dividend which ranks senior to any dividend which would be
paid on our Common Stock. No dividend or distribution can be paid or accrued
unless all accrued dividends in Series B Convertible Preferred Stock are paid in
full. This transaction was deemed to be exempt from the registration
requirements of the Securities Act of 1933 pursuant to Regulation D promulgated
under the Securities Act of 1933.





Stock
Options




In
September 2009, 400,000 stock options held by a former director were exercised.
The Company received net proceeds of $60,000 as a result of the exercise. The
transaction was deemed to be exempt from registration under the Securities Act
in reliance on Rule 701 in that the transaction was under a compensatory benefit
plan as provided under such rule.




Securities
Authorized for Issuance Under Equity Compensation Plans





Please
see Item 12 in this annual report on Form 10-K for information regarding our
securities authorized for issuance under equity compensation plans.




ITEM
6.          SELECTED FINANCIAL
DATA





Not
required.





ITEM
7.          MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS





The
following discussion and analysis provides information that management believes
is relevant to assess and understand our results of operations and financial
condition. This discussion should be read in conjunction with the consolidated
financial statements and footnotes that follow such consolidated financial
statements.




21


Certain
statements contained in this Annual Report on Form 10-K, including in this Item
7, that are not related to historical results, including, without limitation,
statements regarding the Company's business strategy and objectives, near term
operating goals, our expectations regarding the market for our products and
beliefs with respect to opportunities and industry conditions in those markets,
our beliefs about our products and expectations with respect to their
performance and acceptance, regulatory developments, our beliefs about our
employees, our beliefs and intentions with respect to intellectual property, our
beliefs with respect to reimbursement, our beliefs and expectations regarding
competition, our future financial position, our expectations with respect to
future cash needs and the sufficiency of our working capital, and estimated cost
savings, are forward-looking statements within the meaning of Section 27A of the
Securities Act and Section 21E of the Securities Exchange Act of 1934, as
amended (the "Securities Exchange Act") and involve risks and uncertainties.
Although we believe that the assumptions on which these forward-looking
statements are based are reasonable, there can be no assurance that such
assumptions will prove to be accurate and actual results could differ materially
from those discussed in the forward-looking statements. Factors that could cause
or contribute to such differences include, but are not limited to, changes in
law or regulatory policies, unanticipated competition from other similar
businesses, adverse outcomes from litigation, unexpected employee departures or
disruptions, adverse market and general economic factors and other factors
described in Item 1A of this Form 10-K. All forward-looking statements contained
in this Form 10-K are qualified in their entirety by this
statement.





Plan of
Operation





In the
third fiscal quarter of 2008, the Company began selling its products and is no
longer a development stage company. The Company currently has FDA approval to
market the WavSTAT System for detecting pre-cancerous and cancerous tissue in
the colon and to market the LUMA System for use as an adjunct to colposcopy in
the detection of early stage cancer and pre-cancer of the cervix. Our plan is to
add another indication for use in detecting pre-cancer and cancer in the
esophagus. Over the next twelve months, SpectraScience intends to:





·
            Continue
      selling the WavSTAT System in the US and international markets for the
      detection and treatment of colon cancer and
  pre-cancer;





·
            Complete
      WavSTAT System clinical trials related to the diagnosis of esophageal
      cancers;





·
            Begin
      marketing and selling the WavSTAT System in US and international markets
      for the detection of esophageal cancer and
  pre-cancer;





·
            Position
      and begin selling or renting the LUMA System in the US as an adjunct to
      colposcopy to specialized OB/GYN clinics , managed care organizations ,
      teaching hospitals and medical environments where nurse practitioners
      and/or medical clinicians can leverage our technology for effective early
      diagnosis; and





·
            Enhance
      our San Diego facility and grow our organization to allow for the
      manufacture of both WavSTAT and LUMA Systems in-house and also to begin
      the design and planning for the next generation of fluorescence-based
      systems.





Cash
Requirements





SpectraScience
expects to incur significant additional operating losses through 2010, as we
complete clinical trials, continue with outcome-based clinical studies, continue
research and development activities, and ramp up sales and marketing efforts to
sell both the WavSTAT and LUMA Systems. We may incur unexpected expenses, or we
may not be able to meet our revenue forecast, and such events will require us to
seek additional capital.





SpectraScience
has financed its capital requirements principally through the private sale of
equity securities. The Company had cash and cash equivalents of approximately
$3,408,000 at December 31, 2009 and $1,618,000 at December 31, 2008. The
approximate $1,790,000 increase in cash for the fiscal year was a result of net
cash proceeds of approximately $4,308,000 from the sale of Series B Convertible
Preferred Stock and $60,000 from the exercise of stock options offset by
approximately $2,463,000 of cash used in operations and approximately $115,000
related to acquisitions of equipment. We believe that the Company has sufficient
working capital for planned operations for the next twelve months.





SpectraScience’s
future liquidity and capital requirements will depend upon a number of factors,
including but not limited to:





·
            The
      timing and progress of outcome-based clinical
  trials;





·
            The
      timing and extent to which SpectraScience’s products gain market
      acceptance;





·
            The
      timing and expense of developing marketing and distribution
      channels;




22





·
            The
      progress and expense of developing next generation products and new
      applications for the WavSTAT and LUMA
Systems;





·
            The
      potential requirements and related costs for product
      modifications;





·
            The
      timing and expense of various U.S. and foreign regulatory
      filings;





·
            The
      maintenance of various U.S. and foreign government approvals, or the
      timing of receipt of additional
approvals;





·
            The
      status, maintenance and enhancement of SpectraScience’s patent portfolio;
      and




·
            The
      overall effect of the present global economic recession on the ability of
      the Company to generate sales
revenue.




The
Fusion Transaction




On
January 30, 2009, we signed a $6.0 million common stock purchase agreement with
Fusion Capital Fund II, LLC, an Illinois limited liability
company.  Concurrently with entering into the common stock purchase
agreement, we entered into a registration rights agreement with Fusion
Capital.  Under the registration rights agreement, we agreed to file a
registration statement related to the transaction with the U.S. Securities &
Exchange Commission (“SEC”) covering the shares that have been issued or may be
issued to Fusion Capital under the common stock purchase
agreement.  After the SEC has declared effective the registration
statement related to the transaction, which occurred on May 5,
2009,  we received the right over a 24-month period to sell our shares
of common stock to Fusion Capital from time to time in amounts between $25,000
and $1 million, depending on certain conditions as set forth in the agreement,
up to an aggregate of $6.0 million.  The Company will control the
timing and amount of any sales of shares to Fusion Capital.




The
purchase price of the shares related to the $6.0 million of future funding will
be based on the prevailing market prices of the Company’s shares at the time of
sales without any fixed discount.  Fusion Capital will not have the
right or the obligation to purchase any shares of our common stock on any
business day that the price of our common stock is below $0.15.  The
common stock purchase agreement may be terminated by us at any time at our
discretion without any cost to us.  There are no negative covenants,
restrictions on future fundings, penalties or liquidated damages in the
agreement.  The proceeds to be received by the Company under the
common stock purchase agreement will be used for working capital and general
corporate purposes.




In
consideration for entering into the agreement, upon execution of the common
stock purchase agreement we have issued to Fusion Capital 1,094,017 shares of
our common stock as a commitment fee. Also, we will issue to Fusion Capital an
additional 547,009 shares as a commitment fee pro rata as we receive the $6.0
million of future funding.




As of
March 26, 2010 we had not sold Fusion Capital any shares of stock under the
common stock purchase agreement..




Results
of Operations




The
following discussion should be read in conjunction with the consolidated
Financial Statements and Notes thereto appearing elsewhere in this
report.




Comparison
of years ended December 31, 2009 and December 31, 2008




Revenue




The
Company recognized approximate revenue of $167,000 for the fiscal year ending
December 31, 2009 as compared to approximate revenue of $61,000 for the fiscal
year ending December 31, 2008. The increase is a result of the sale of a greater
number of WavSTAT Optical Biopsy Systems in fiscal 2009 as compared to fiscal
2008.




Cost
of Revenue




Cost of
goods increased from approximately $27,000 for the fiscal year ending December
31, 2008 to approximately $111,000 for the fiscal year ending December 31, 2009.
The increase of $84,000 is a result of the sale of a greater number of WavSTAT
Optical Biopsy Systems in the most recent fiscal year.




Operating
Expenses




Consolidated
operating expenses were approximately $4,493,000 (of which approximately
$696,000 was for non-cash compensation from stock options) for the fiscal
year ended December 31, 2009, as compared to approximately $5,305,000 (of which
approximately $992,000 was for non-cash compensation from stock options)
for the comparable period one year ago. The net decrease of $812,000 was
comprised of an approximate $93,000 decrease in research and development
expenses, a $274,000 decrease in general and administrative expenses and a
$445,000 decrease in sales and marketing expenses. The overall decreases were a
result of the Company’s efforts to reduce expenses in response to the downturn
in the overall economy.


23




Research
and development expenses decreased by approximately $93,000 due to an decrease
of approximately $446,000 in payroll expense, a $171,000 decrease in stock
option compensation expense, a $152,000 decrease in product development expense,
an $81,000 decrease in clinical trial expense, a $40,000 decrease in research
consulting expense, a $33,000 decrease in production supplies expense, a $14,000
decrease in software expense, a $7,000 decrease in design expense and a $10,000
decrease in all other research and development expenses, offset by an
approximate $761,000 non-cash increase in LUMA asset impairment expense and an
approximate $100,000 increase in inventory obsolescence associated with WavSTAT
inventory. All of the decreases were a result of the Company’s aggressive cost
reduction efforts in response to the recessionary economy. The increase in asset
impairment and inventory obsolescence expense is primarily the result of
management’s analysis of the reduction in the fair value of those
assets.




General
and administrative expenses decreased approximately $274,000 due to an
approximate $104,000 decrease in administrative payroll expense, a $67,000
decrease in recruiting expense, a $67,000 decrease in travel expenses, a $64,000
decrease in audit related expense, a $63,000 decrease in consulting expense, a
$23,000 decrease in stock compensation expense, a $15,000 decrease in internet
expense, a $12,000 decrease in advertising expense, a $4,000 decrease in legal
expense, offset by an approximate $141,000 non-cash increase in amortization
expense and a $4,000 increase in all other expenses. The decreases in the
majority of expense categories are a result of the Company’s aggressive cost
reduction efforts in response to the recessionary economy. The increase in
amortization expense is primarily a result of the amortization of a prepaid
non-cash commitment fee related to securing a financing facility in January of
2009.




Sales and marketing expenses decreased
by approximately $445,000 as compared to the prior fiscal year. The decrease was
comprised of approximately $216,000 in sales payroll expense, a $103,000
decrease in stock compensation expense, a $37,000 decrease in consulting
expense, a $37,000 decrease in trade show expense, a $21,000 decrease in
advertising expense, a $21,000 decrease in convention expense and a $10,000
decrease in all other sales expenses. The decreases in all expense categories
are a result of the Company’s aggressive cost reduction efforts implemented as a
result of the recessionary economy.





Other
Income




Other
income, net decreased approximately $121,000 due to relatively lower interest
earnings on lower average cash balances for the year as compared to the prior
fiscal year.





Liquidity
and Capital Resources





On
December 31, 2009, the Company had a cash balance of $3,408,237 as compared with
a cash balance of $1,618,181 at December 31, 2008, representing an increase of
$1,790,056 in cash for the period. The cash balances increased primarily due to
sales of Series B Convertible Preferred Stock offset by working capital used in
operations. Historically, we have incurred minimal capital equipment
expenditures and no large capital outlays are foreseen. We believe that the
Company has sufficient working capital for planned operations for the next
twelve months.





From May
through December 31, 2009, as a part of a Units offering, the Company sold
25,000,000 shares of Preferred Stock to accredited investors for an aggregate
consideration of $5,000,000. The Company received net cash proceeds of
$4,308,446 after the payment of finders’ fees and expenses of
$691,554.





On
January 30, 2009, the Company entered into a common stock purchase agreement
with Fusion Capital. Under the purchase agreement, Fusion Capital is obligated,
under certain conditions, to purchase shares from us in an aggregate amount of
$6.0 million from time to time over a twenty-four (24) month period. As of March
26, 2010, the Company had not sold any shares to Fusion Capital.





SpectraScience
expects to incur significant additional operating losses through at least 2010,
as we complete clinical trials, begin outcome-based clinical studies and
increase sales and marketing efforts to commercialize the WavSTAT systems. If we
do not receive sufficient funding, the Company may be unable to continue as a
going concern. We may incur unknown expenses or we may not be able to meet our
revenue forecast, and one or more of these circumstances would require us to
seek additional capital. We may not be able to obtain equity capital or debt
funding on terms that are acceptable. Even if the Company receives additional
funding, such proceeds may not be sufficient to allow the Company to sustain
operations until it attains profitability and positive cash flows from
operations.




Off Balance Sheet
Arrangements




The
Company has no Off Balance Sheet arrangements.




Critical Accounting Policies
and Estimates




This
discussion and analysis of our financial condition and results of operations are
based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America. The preparation of these consolidated financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate these estimates, including
those related to intangibles, income taxes, financing operations, contingencies
and litigation. We base our estimates on historical experience and on various
other assumptions that are believed to be reasonable under the circumstances,
the results of which form the basis for making judgments about the carrying
values of assets and liabilities that are not readily apparent from other
sources. Actual results may differ from these estimates under different
assumptions or conditions.


24




We have
identified the policies below as critical to our business operations and the
understanding of our results of operations. The impact and any associated risks
related to these policies on our business operations is discussed throughout
this Management's Discussion and Analysis of Financial Condition and Results of
Operations where such policies affect our reported and expected financial
results. Note that our preparation of this Report on Form 10-K requires us to
make estimates and assumptions that affect the reported amount of assets and
liabilities, disclosure of contingent assets and liabilities at the date of our
consolidated financial statements, and the reported amount of revenue, if any,
and expenses during the reporting period. There can be no assurance that actual
results will not differ from those estimates.





Revenue
Recognition




In
accordance with Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, we
recognize revenues when persuasive evidence of an arrangement exists, delivery
has occurred or services have been rendered, the price is fixed or determinable
and collectability is reasonably assured. Revenue from the sale of our products
is generally recognized when title and risk of loss transfers to the customer,
the terms of which are generally free on board shipping point. We use customer
purchase orders to determine the existence of an arrangement. We use shipping
documents and third-party proof of delivery to verify that title has
transferred. We assess whether the fee is fixed or determinable based upon the
terms of the agreement associated with the transaction. To determine whether
collection is probable, we assess a number of factors, including past
transaction history with the customer and the creditworthiness of the
customer.





Accounting
For Transactions Involving Stock Compensation





We
account for stock-based compensation under the provisions of FASB ASC Topic
718, Compensation—Stock
Compensation,or ASC 718, which requires the measurement and
recognition of compensation expense for all stock-based awards made to employees
and directors based on estimated fair values on the grant date. We adopted ASC
718 on January 1, 2006 using the modified prospective method. We estimate
the fair value of stock-based awards on the date of grant using the
Black-Scholes-Merton option pricing model, or Black-Scholes model.These
standards require us to expense employee stock options and other share-based
payments. The Company has been recording to expense the fair value of employee
and non-employee options. These expenses amounted to approximately $696,000 and
$992,000 for the years ended December 31, 2009 and 2008,
respectively.




Inventory
Valuation




We state
our inventories at the lower of cost or market value, determined on a specific
cost basis. We provide inventory allowances when conditions indicate that the
selling price could be less than cost due to obsolescence and reductions in
estimated future demand. We balance the need to maintain strategic inventory
levels with the risk of obsolescence due to changing technology and customer
demand levels. Unfavorable changes in market conditions may result in a need for
additional inventory reserves that could adversely impact our gross margins.
Conversely, favorable changes in demand could result in higher gross margins
when we sell products.





Valuation
of Long-lived Assets




Our
long-lived assets consist of property and equipment and intangible assets.
Equipment is carried at cost and is depreciated over the estimated useful lives
of the assets, which are generally two to three years, and leasehold
improvements are amortized over the lesser of the lease term or the estimated
useful lives of the improvements. The straight-line method is used for
depreciation and amortization. Equipment related to our LUMA Systems is not
currently being depreciated but is reviewed for impairment at the end of each
reporting period. Intangible assets consist of patents and trademarks, which are
amortized using the straight-line method over the estimated useful lives of the
assets. We do not capitalize external legal costs and filing fees associated
with obtaining patents on our new discoveries. Acquired intellectual property is
recorded at cost and is amortized over its estimated useful life. We believe the
useful lives we assigned to these assets are reasonable. The Company assesses
the recoverability of long-lived assets whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. These computations utilize judgments and assumptions inherent in
management’s estimate of future cash flows to determine recoverability of these
assets. If management’s assumptions about these assets were to change as a
result of events or circumstances, the Company may be required to record an
impairment loss. With respect to the Company’s long-lived assets, the Company
recorded impairment charges of approximately $761,000 and $0 for the years ended
December 31, 2009 and 2008.




ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK




Not
required.




ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.





Consolidated
audited financial statements for the years ended December 31, 2009 and 2008 are
filed as part of this Form 10-K.


25




SpectraScience,
Inc. and Subsidiary


Consolidated
Financial Statements


Years
Ended December 31, 2009, and 2008




PageReport
      of Independent Registered Public Accounting Firm
              
              
              27Consolidated
      Balance Sheets as of December 31, 2009 and 2008
              
              
              28Consolidated
      Statements of Operations for the years ended December 31, 2009 and
      2008
              
              
              29Consolidated
      Statements of Shareholders’ Equity for the years ended December 31, 2009
      and 2008
              
              
              30Consolidated
      Statements of Cash Flows for the years ended December 31, 2009 and
      2008
              
              
              31Notes
      to Consolidated Financial Statements
              
              
              32




26




Report
of Independent Registered Public Accounting Firm




To the
Board of Directors and Shareholders


SpectraScience,
Inc. and Subsidiary





We have
audited the accompanying consolidated balance sheets of SpectraScience, Inc. and
subsidiary as of December 31, 2009 and 2008 and the related consolidated
statements of operations, shareholders’ equity, and cash flows for the years
then ended. These financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these financial
statements based on our audit.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of SpectraScience, Inc. and
subsidiary as of December 31, 2009 and 2008, and the results of their operations
and their cash flows for the years then ended, in conformity with U.S. generally
accepted accounting principles.





We were
not engaged to examine management’s assessment of the effectiveness of
SpectraScience, Inc’s internal control over financial reporting as of December
31, 2009, included in Item 9(A)(T) of Form 10-K and, accordingly, we do not
express an opinion thereon.





/s/
McGladrey & Pullen





Des
Moines, Iowa


March 31,
2010




27




SpectraScience,
Inc. and Subsidiary


Consolidated
Balance Sheets


December
31, 2009 and 2008





December 31,
                  2009
                
                
                December 31,
                  2008ASSETSCurrent
      assets:Cash
      and cash equivalents
                
                $
                3,408,237
                
                
                $
                1,618,181Accounts
      receivable
                
                
                40,271
                
                
                
                23,877Inventories
                
                
                405,675
                
                
                
                465,881Prepaid
      expenses and other current assets
                
                
                195,568
                
                
                
                85,344Total
      current assets
                
                
                4,049,751
                
                
                
                2,193,283Fixed
      assets, net
                
                
                1,139,839
                
                
                
                1,876,738Patents,
      net
                
                
                2,915,984
                
                
                
                3,165,550TOTAL
      ASSETS
                
                $
                8,105,574
                
                
                $
                7,235,571LIABILITIES
      AND SHAREHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
                
                $
                219,783
                
                
                $
                345,762Accrued
      expenses
                
                
                167,475
                
                
                
                88,081Total
      liabilities
                
                
                387,258
                
                
                
                433,843COMMITMENTSSHAREHOLDERS’
      EQUITYSeries
      B Convertible Preferred Stock, $.01 par value:Authorized
      – 25,000,000; Shares issued and outstanding – 25,000,000 shares at
      December 31, 2009 (no shares at December 31, 2008), $5,000,000 liquidation
      value plus accumulated and unpaid dividends of $99,685 as of December 31,
      2009
                
                
                250,000
                
                
                
                —Common
      stock, $.01 par value:Authorized
      — 160,000,000 sharesIssued
      and outstanding—70,142,615 and 68,613,598 shares at December 31, 2009 and
      2008, respectively
                
                
                701,426
                
                
                
                686,136Additional
      paid-in capital
                
                
                25,511,360
                
                
                
                17,835,865Accumulated
      deficit
                
                
                (18,744,470
                )
                
                
                (11,720,273
                )TOTAL
      SHAREHOLDERS’ EQUITY
                
                
                7,718,316
                
                
                
                6,801,728TOTAL
      LIABILITIES AND SHAREHOLDERS’ EQUITY
                
                $
                8,105,574
                
                
                $
                7,235,571





See
accompanying notes to the consolidated financial statements




28




SpectraScience,
Inc. and Subsidiary


Consolidated
Statements of Operations


For the
Years Ended December 31, 2009 and 2008





Year Ended
                  December 31,2009
                
                
                2008Revenue
                
                $
                167,123
                
                
                $
                60,560Cost
      of revenue
                
                
                110,572
                
                
                
                27,130Gross
      profit
                
                
                56,551
                
                
                
                33,430Operating
      expenses:Research
      and development
                
                
                2,126,574
                
                
                
                2,220,007General
      and administrative
                
                
                2,007,380
                
                
                
                2,280,867Sales
      and marketing
                
                
                359,409
                
                
                
                803,888Total
      operating expenses
                
                
                4,493,363
                
                
                
                5,304,762Operating
      loss
                
                
                (4,436,812
                )
                
                
                (5,271332
                )Other
      income, net
                
                
                4,625
                
                
                
                126,430Net
      loss
                
                
                (4,432,187
                )
                
                
                (5,144,902
                )Deemed
      dividend on preferred stock
                
                
                (2,592,010
                )
                
                
                —Accumulated
      but unpaid dividend on preferred stock
                
                
                (99,685
                )
                
                
                —Net
      loss applicable to common shareholders
                
                $
                (7,123,882
                )
                
                $
                (5,144,902
                )Basic
      and diluted net loss per share
                
                $
                (0.10
                )
                
                $
                (0.08
                )Weighted
      average common shares outstanding
                
                
                69,780,156
                
                
                
                66,344,469





See
accompanying notes to the consolidated financial statements




29




SpectraScience,
Inc. and Subsidiary


Consolidated
Statements of Shareholders’ Equity


For the
Year’s Ended December 31, 2009 and 2008




Preferred Stock
                  
                  
                  Common Stock
                  
                  
                  Additional
                    Paid-In
                  
                  
                  Accumulated
                  
                  
                  Total
                    Shareholders’Shares
                  
                  
                  Amount
                  
                  
                  Shares
                  
                  
                  Amount
                  
                  
                  Capital
                  
                  
                  Deficit
                  
                  
                  EquityBalance,
      December 31, 2007
                  
                  2,000,000
                  
                  
                  20,000
                  
                  
                  
                  58,992,944
                  
                  
                  $
                  589,929
                  
                  
                  $
                  16,430,997
                  
                  
                  $
                  (6,575,371
                  )
                  
                  $
                  10,465,555Stock
      based compensation – consultants
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  51,955
                  
                  
                  
                  
                  
                  
                  
                  51,955Stock
      based compensation – employees
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  940,268
                  
                  
                  
                  
                  
                  
                  
                  940,268Stock
      options exercised
                  
                  
                  
                  
                  
                  
                  
                  
                  20,000
                  
                  
                  
                  200
                  
                  
                  
                  2,800
                  
                  
                  
                  
                  
                  
                  
                  3,000Sale
      of common stock at $0.70 per share
                  
                  
                  
                  
                  
                  
                  
                  
                  736,856
                  
                  
                  
                  7,369
                  
                  
                  
                  437,983
                  
                  
                  
                  
                  
                  
                  
                  445,352Conversion
      of Series A Preferred Stock
                  
                  
                  (2,000,000
                  )
                  
                  (20,000
                  )
                  
                  
                  8,000,000
                  
                  
                  
                  80,000
                  
                  
                  
                  (60,000
                  )
                  
                  
                  
                  
                  
                  
                  —Conversion
      of Series A Preferred Stock Warrants
                  
                  
                  
                  
                  
                  $
                  
                  
                  
                  
                  753,798
                  
                  
                  
                  7,538
                  
                  
                  
                  (7,538
                  )
                  
                  
                  
                  
                  
                  
                  —Common
      Stock issued for Services
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  110,000
                  
                  
                  
                  1,100
                  
                  
                  
                  39,400
                  
                  
                  
                  
                  
                  
                  
                  40,500Net
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (5,144,902
                  )
                  
                  
                  (5,144,902
                  )Balance,
      December 31, 2008
                  
                  
                  —
                  
                  
                  $
                  —
                  
                  
                  
                  68,613,598
                  
                  
                  $
                  686,136
                  
                  
                  $
                  17,835,865
                  
                  
                  $
                  (11,720,273
                  )
                  
                  $
                  6,801,728Stock
      based compensation – consultants
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  133,402
                  
                  
                  
                  
                  
                  
                  
                  133,402Stock
      based compensation – employees
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  562,222
                  
                  
                  
                  
                  
                  
                  
                  562,222Stock
      options exercised
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  400,000
                  
                  
                  
                  4,000
                  
                  
                  
                  56,000
                  
                  
                  
                  
                  
                  
                  
                  60,000Common
      Stock issued for services
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,129,017
                  
                  
                  
                  11,290
                  
                  
                  
                  273,415
                  
                  
                  
                  
                  
                  
                  
                  284,705Sale
      of Series B Preferred Stock at $0.20 per share
                  
                  
                  25,000,000
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  4,308,446
                  
                  
                  
                  
                  
                  
                  
                  4,308,446Deemed
      Dividend – Preferred Stock
                  
                  
                  
                  
                  
                  
                  250,000
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2,342,010
                  
                  
                  
                  (2,592,010
                  )
                  
                  
                  —Net
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4,432,187
                  )
                  
                  
                  (4,432,187
                  )Balance,
      December 31, 2009
                  
                  
                  25,000,000
                  
                  
                  $
                  250,000
                  
                  
                  
                  70,142,615
                  
                  
                  $
                  701,426
                  
                  
                  $
                  25,511,360
                  
                  
                  $
                  (18,744,470
                  )
                  
                  $
                  7,718,316




See
accompanying notes to the consolidated financial statements




30




SpectraScience,
Inc. and Subsidiary


Consolidated
Statements of Cash Flows


For the
years ended December 31, 2009 and 2008





Year
      Ended December 31,2009
                
                
                2008OPERATING
      ACTIVITIES:Net
      loss
                
                $
                (4,432,187
                )
                
                $
                (5,144,902
                )Adjustments
      to reconcile net loss to cash used in operating
activities:Depreciation
      and amortization
                
                
                290,509
                
                
                
                281,594Stock-based
      compensation employees
                
                
                562,222
                
                
                
                940,268Stock-based
      compensation consultants
                
                
                133,402
                
                
                
                51,955Impairment
      of LUMA equipment
                
                
                760,776
                
                
                
                —Provision
      for inventory obsolescence
                
                
                100,000
                
                
                
                —Amortization
      of prepaid financing costs
                
                
                141,263
                
                
                
                —Fair
      market value of common stock issued for services
                
                
                284,705
                
                
                
                40,500Changes
      in operating assets and liabilities:Accounts
      receivable
                
                
                (16,394
                )
                
                
                (23,877
                )Inventory
                
                
                10,596
                
                
                
                (179,172
                )Prepaid
      expenses and other assets
                
                
                (251,487
                )
                
                
                (43,907
                )Accounts
      payable
                
                
                (125,979
                )
                
                
                190,711Accrued
      compensation and taxes
                
                
                79,394
                
                
                
                75,618Net
      cash used in operating activities
                
                
                (2,463,180
                )
                
                
                (3,811,212
                )INVESTING
      ACTIVITIES:Acquisition
      of fixed assets
                
                
                (115,210
                )
                
                
                (207,136
                )Net
      cash used in investing activities
                
                
                (115,210
                )
                
                
                (207,136
                )FINANCING
      ACTIVITIES:Net
      proceeds from issuance of common stock
                
                
                —
                
                
                
                445,352Net
      proceeds from issuance of preferred stock
                
                
                4,308,446
                
                
                
                —Proceeds
      from exercise of stock options
                
                
                60,000
                
                
                
                3,000Net
      cash provided by financing activities
                
                
                4,368,446
                
                
                
                448,352Net
      increase (decrease) in cash and cash equivalents
                
                
                1,790,056
                
                
                
                (3,569,996
                )CASH
      AND CASH EQUIVALENTS AT BEGINNING OF YEAR
                
                
                1,618,181
                
                
                
                5,188,177CASH
      AND CASH EQUIVALENTS AT END OF YEAR
                
                $
                3,408,237
                
                
                $
                1,618,181Supplemental
      disclosure of non-cash investing and financing activities:Reclassification
      of inventory to long-term assets
                
                $
                —
                
                
                $
                758,147





See
accompanying notes to the consolidated financial statements




31




SpectraScience,
Inc. and Subsidiary


Notes to
Consolidated Financial Statements




Note 1:
Organization and Description of Business





SpectraScience,
Inc. was incorporated in the State of Minnesota on May 4, 1983 as GV Medical,
Inc. In October 1992, GV Medical discontinued its prior business, refocused its
development efforts and changed its name to SpectraScience, Inc. The “Company”,
hereinafter, refers to SpectraScience, Inc. and its wholly owned subsidiary Luma
Imaging Corp. From 1996, the Company primarily focused on developing the WavSTAT
Optical Biopsy System (“WavSTAT System.”).





The
Company has developed and received FDA approval to market a proprietary,
minimally invasive technology that optically illuminates tissue in real-time to
distinguish between normal, pre-cancerous or cancerous cells without the need to
remove the subject cell tissue from the body to make such determinations. The
WavSTAT System operates by using cool, safe UV laser light to optically
illuminate and analyze tissue, enabling the physician to make an instant
diagnosis during endoscopy when screening for cancer, and if warranted, to begin
immediate treatment during the same procedure. The WavSTAT is FDA approved for
colon cancer detection.





On
November 6, 2007, the Company acquired the assets of Luma Imaging Corporation
(“LUMA”) in an equity transaction accounted for as an acquisition of assets and
now operates LUMA as a wholly owned subsidiary of the Company.   LUMA had
acquired the assets from a predecessor company that had developed, and received
FDA approval for, a non-invasive diagnostic imaging system that can detect
cervical cancer precursors and which utilizes an underlying technology that is
similar to that of the WavSTAT System. The addition of the LUMA technology to
the Company’s existing WavSTAT System technology provides the Company with a
broad suite of fluorescence-based intellectual property and know-how. LUMA
received FDA approval as an adjunct to colposcopy in March 2006.





In the
third fiscal quarter of 2008, the Company began selling its products and is no
longer a development stage company.





Note 2:
Significant Accounting Policies





Revenue
Recognition




In
accordance with Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, the
Company recognizes revenues when persuasive evidence of an arrangement exists,
delivery has occurred or services have been rendered, the price is fixed or
determinable and collectibility is reasonably assured. Revenue from the sale of
the Company’s products is generally recognized when title and risk of loss
transfers to the customer, the terms of which are generally free on board
shipping point. The Company uses customer purchase orders to determine the
existence of an arrangement. The Company uses shipping documents and third-party
proof of delivery to verify that title has transferred. The Company assesses
whether the fee is fixed or determinable based upon the terms of the agreement
associated with the transaction. To determine whether collection is probable,
the Company assesses a number of factors, including past transaction history
with the customer and the creditworthiness of the customer.




Consolidation




The
accompanying consolidated financial statements include the accounts of
SpectraScience, Inc. and its wholly owned subsidiary Luma Imaging Corp. All
significant intercompany balances and transactions have been eliminated in
consolidation.




Risks
and Uncertainties




The
Company operates in an industry that is subject to intense competition,
government regulation and rapid technological change. The Company's operations
are subject to significant risk and uncertainties including financial,
operational, technological, regulatory and other risks, including the potential
risk of business failure.




Use
of Estimates




The
Company prepares its consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America, which
requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and disclosures made in the accompanying
notes to the financial statements. Significant estimates made by management
include, among others, realization of long-lived assets, assumptions used to
value stock options, assumptions used to value the common stock issued and the
assets acquired in the Luma acquisition and the realization of intangible
assets. Actual results could differ from those estimates.




Cash
Equivalents




Highly
liquid investments with original maturities of three months or less when
purchased are considered to be cash equivalents. Financial instruments which
potentially subject the Company to concentrations of credit risk consist
primarily of cash and cash equivalents. The Company maintains its cash and cash
equivalents with high-credit quality financial institutions. At times, such
amounts may exceed insured limits. The Company has not experienced any losses in
such accounts and believes it is not exposed to any significant credit risk on
its cash equivalent accounts.


32




Inventory
Valuation




We state
our inventories at the lower of cost or market value, determined on a specific
cost basis. We provide inventory allowances when conditions indicate that the
selling price could be less than cost due to obsolescence and reductions in
estimated future demand. We balance the need to maintain strategic inventory
levels with the risk of obsolescence due to changing technology and customer
demand levels. Unfavorable changes in market conditions may result in a need for
additional inventory reserves that could adversely impact our gross margins.
Conversely, favorable changes in demand could result in higher gross margins
when we sell products.





Valuation
of Long-lived Assets




Our
long-lived assets consist of property and equipment and intangible assets.
Equipment is carried at cost and is depreciated over the estimated useful lives
of the assets, which are generally two to three years, and leasehold
improvements are amortized over the lesser of the lease term or the estimated
useful lives of the improvements. The straight-line method is used for
depreciation and amortization. Equipment related to our LUMA Systems is not
currently being depreciated but is reviewed for impairment at the end of each
reporting period. Intangible assets consist of patents and trademarks, which are
amortized using the straight-line method over the estimated useful lives of the
assets. We do not capitalize external legal costs and filing fees associated
with obtaining patents on our new discoveries Acquired intellectual property is
recorded at cost and is amortized over its estimated useful life. We believe the
useful lives we assigned to these assets are reasonable. The Company assesses
the recoverability of long-lived assets whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. These computations utilize judgments and assumptions inherent in
management’s estimate of future cash flows to determine recoverability of these
assets. If management’s assumptions about these assets were to change as a
result of events or circumstances, the Company may be required to record an
impairment loss. With respect to the Company’s long-lived assets, the Company
recorded impairment charges of approximately $761,000 and $0 for the years ended
December 31, 2009 and 2008.





Income
Taxes





Income
taxes are provided for the tax effects of transactions reported in the
consolidated financial statements and consist of taxes currently due plus
deferred income taxes. Deferred income taxes are recognized for temporary
differences between the financial statement and tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future.
Deferred income taxes are also recognized for net operating loss carryforwards
that are available to offset future taxable income and research and development
credits. Valuation allowances are established when necessary to reduce deferred
tax assets to the amount expected to be realized.





FASB ASC
Topic 740, Income Taxes (“ASC 740”), clarifies the accounting for uncertainty in
income taxes recognized in the financial statements. ASC 740 provides that a tax
benefit from an uncertain tax position may be recognized when it is more likely
than not that the position will be sustained upon examination, including
resolutions of any related appeals or litigation processes, based on the
technical merits of the position. Income tax positions must meet a
more-likely-than-not recognition threshold to be recognized. ASC 740 also
provides guidance on measurement, derecognition, classification, interest and
penalties, accounting in interim periods, disclosure and transition. We adopted
these provisions of ASC 740 on January 1, 2007, and the adoption did not have a
material impact on our consolidated financial position or results of
operations. We have determined that the Company does not have uncertain tax
positions on its 2004, 2005, 2006, 2007 and 2008 tax returns. Based on
evaluation of the 2009 transactions and events, the Company does not have any
material uncertain tax positions that require measurement. Because the Company
had a full valuation allowance on its deferred tax assets as of December 31,
2009 and 2008, the Company has not recognized any tax benefits since
inception.





Our
policy is to recognize interest and/or penalties related to income tax matters
in income tax expense. We had no accrual for interest or penalties on our
consolidated balance sheets at December 31, 2009 or 2008, and have not
recognized interest and/or penalties in the consolidated statement of operations
for the years ended December 31, 2009 or 2008.





We are
subject to taxation in the US and the state of California. All of our tax years
are subject to examination by the US and California tax authorities due to the
carryforward of unutilized net operating losses.





Stock-Based
Compensation





We
account for stock-based compensation under the provisions of FASB ASC Topic
718, Compensation—Stock
Compensation(“ASC 718”), which
requires the measurement and recognition of compensation expense for all
stock-based awards made to employees and directors based on estimated fair
values on the grant date. We adopted ASC 718 on January 1, 2006. We
estimate the fair value of stock-based awards on the date of grant using the
Black-Scholes-Merton option pricing model (“Black-Scholes model”). The value of
the portion of the award that is ultimately expected to vest is recognized as
expense over the requisite service periods using the straight-line method. We
estimate forfeitures at the time of grant and revise our estimate in subsequent
periods if actual forfeitures differ from those estimates.


33





We
account for stock-based compensation awards to non-employees in accordance with
FASB ASC Topic 505-50,Equity-Based Payments to
Non-Employees(“ASC
505-50”). Under ASC 505-50, we determine the fair value of the warrants or
stock-based compensation awards granted as either the fair value of the
consideration received or the fair value of the equity instruments issued,
whichever is more reliably measurable.


All
issuances of stock options or other equity instruments employees and to
non-employees as the consideration for goods or services received by the Company
are accounted for based on the fair value of the equity instruments issued. Any
stock options issued to non-employees are recorded in expense and additional
paid-in capital in stockholders’ equity over the applicable service periods
using variable accounting through the vesting dates based on the fair value of
the options at the end of each period.





As of
December 31, 2009, the Company had one stock-based employee compensation plan
(the “Option Plan"). The Option Plan provides for the grant of incentive stock
options (“ISOs") to full-time employees (who may also be directors) and
nonqualified stock options ("NSOs") to non-employee directors, consultants,
vendors or providers of services and expires on January 30, 2011. The exercise
price of any ISO may not be less than the fair market value of the common stock
on the date of grant and the term shall not exceed ten years. The amount
reserved under the Option Plan equals 15% of the outstanding shares of the
Company, totaling 10,521,392 reserved at December 31, 2009. At December 31, 2009
the Company had outstanding 7,450,000 options under the Option Plan representing
approximately 10.62% of the outstanding shares (5,050,000 of which were
exercisable), with 3,071,392 available for future issuance. Awards under the
Company’s Option Plan generally vest over three years.




For the years ended December 31, 2009
and 2008, stock-based compensation was approximately $696,000 and $992,000,
respectively. In fiscal 2009, stock option expense was approximately $259,000
for research and development, $472,000 in general and administration and
($35,000) in sales and marketing. In fiscal 2008, stock option expense was
approximately $430,000 in research and development, $495,000 in general and
administrative and $67,000 in sales and marketing.





The fair
value of options granted were estimated at the date of grant using a
Black-Scholes option-pricing model which includes several variables including
expected life, risk free interest rate, expected stock price volatility, stock
option exercise patterns and expected dividend yield. The Company also must
estimate forfeitures for employee stock options. The following average
assumptions were used to value non-employee options in the past two years:




2009
                  
                  
                  2008Expected
      life
                  
                  5
      years
                  
                  
                  5
      yearsRisk-free
      interest rate
                  
                  
                  2.58
                  %
                  
                  
                  2.63
                  %Expected
      volatility
                  
                  
                  124
                  %
                  
                  
                  125
                  %Expected
      dividend yield
                  
                  
                  0
                  %
                  
                  
                  0
                  %




Management
used the following assumptions to value employee options over the past two
years:




2009
                  
                  
                  2008Expected
      life
                  
                  5
      years
                  
                  
                  5
      yearsRisk-free
      interest rate
                  
                  
                  2.36
                  %
                  
                  
                  2.21
                  %Expected
      volatility
                  
                  
                  124
                  %
                  
                  
                  123
                  %Expected
      dividend yield
                  
                  
                  0
                  %
                  
                  
                  0
                  %




In
addition to the above, management estimated the forfeitures on employee options
under the Option Plan would have negligible effects because such forfeitures
would be a very small percentage. Management believes that options granted have
been to a group of individuals that have a high desire to see the Company
succeed and have aligned themselves to that end.





The
expected lives used in the calculations were selected by management based on
past experience, forward looking profit forecasts and estimates of what the
trading price of the Company’s stock might be at different future dates.
Risk-free interest rates used are the 5-year U.S. Treasury rate as published for
the applicable measurement dates.





Volatility
is a calculation based on the Company’s stock price and historical trading
volume and becomes a risk-measurement component included in the Black-Scholes
calculation of estimated fair value. Management computed and reviewed its
volatility calculation for reasonableness and found it to be acceptable based on
a number of factors including the Company’s current market capitalization and
comparisons to other companies similar to SpectraScience, Inc.





Patents





The
Company accounts for acquired intangible assets under FASB ASC Topic 350 Goodwill and Other Intangibles –30General Intangibles
Other than Goodwill. On August 2, 2004, at the inception of the Successor
Company, the Company capitalized $290,000 to value eight WavSTAT System patents.
On November 6, 2007, coincident with the acquisition of the LUMA assets, the
Company capitalized an additional $3,226,000 to value the 28 patents acquired.
In both cases, the capitalized amounts were determined based upon an independent
appraisal using a market-based forecast which utilized comparable assumed
royalty revenue streams over several possible scenarios. These forecast cash
flows were then discounted to present value to determine
valuation.


34




All
patents are amortized over the shorter of their remaining legal lives or
estimated economic lives. When acquired, the WavSTAT System patents had an
average remaining useful life of 14 years, while the LUMA patents had an average
remaining life of approximately 16 years. Amortization expense associated with
patents for both of the fiscal years ended December 31, 2009 and 2008 was
approximately $250,000. Patents are reported net of accumulated amortization of
$600,017 and $350,450 at December 31, 2009 and 2008, respectively. Amortization
expense in each of the five years subsequent to December 31, 2009 is expected to
approximate $250,000 per year.




Research
and Development




Research
and development costs are expensed as incurred. There may be cases in the future
where certain research and development costs such as software development costs
are capitalized. For the years ended December 31, 2009 and 2008, research and
development costs were approximately $2,127,000 and $2,220,000, respectively. In
2009 the Company recognized approximately $761,000 of non-cash expense related
to the impairment of LUMA assets classified as long lived assets (equipment) as
well as approximately $100,000 in WavSTAT inventory obsolescence
expense.





Accounts
Receivable




Receivables
are carried at original invoice amount less payment received and an estimate
made for doubtful receivables based on a review of all outstanding amounts on a
monthly basis. Receivables are generally considered past due 30 days after
payment date as specified on the invoice. We determine allowance for doubtful
accounts by regularly evaluating individual receivables and considering a
creditor’s financial condition, credit history and current economic conditions.
Receivables are written off when deemed uncollectible. Recoveries of previously
written off receivables previously written off are recorded when
received.




Inventories


Inventories
are valued at the lower of cost (using the first-in, first-out method) or market
value.





Fixed
Assets




Fixed
assets are stated at cost less accumulated depreciation. Depreciation expense is
computed using the straight-line method over the estimated useful lives of the
related assets, which range from two to three years. For the years ended
December 31, 2009 and 2008, depreciation expense was approximately $41,000 and
$32,000, respectively. Repairs and maintenance are charged to expense as
incurred while improvements are capitalized. Upon the sale, retirement or
disposal of fixed assets, the accounts are relieved of the cost and the related
accumulated depreciation with any gain or loss recorded to the consolidated
statements of operations. The fixed asset account balance at December 31, 2009
and 2008 includes approximately $1,786,000 and $1,837,000 of LUMA inventory,
respectively. The LUMA inventory included in fixed asset accounts is evaluated
for impairment at the end of each reporting period. During 2009, the Company
evaluated the ongoing value of the LUMA inventory due to difficulties
successfully marketing the LUMA System. Based on this evaluation, the Company
determined that LUMA assets with a carrying value of approximately $1,786,000
were impaired and wrote them down by approximately $761,000 to their estimated
fair value. The estimated fair value was based upon an estimate of market value
in a favorable arm’s length transaction.




Fair
Value of Financial Instruments




The
carrying amount of the Company's cash and cash equivalents, accounts receivable,
accounts payable and accrued liabilities approximate their estimated fair values
due to the short-term maturities of those financial instruments.




Earnings
(Loss) Per Share




Basic earnings (loss) per share is
computed by dividing net income (loss) available to common shareholders by the
weighted average number of common shares assumed to be outstanding during the
period of computation. Diluted earnings per share is computed similar to basic
earnings per share except that the denominator is increased to include the
number of additional common shares that would have been outstanding if the
potential common shares had been issued and if the additional common shares were
dilutive. For all periods presented, basic and diluted loss per share are the
same, as any additional common stock equivalents would be antidilutive.
Potentially dilutive shares of common stock that have been excluded from the
calculation of the weighted average number of dilutive common shares. For the
year ended December 31, 2009, utilizing the treasury stock method, there were
16,889,258 additional potentially dilutive shares of common stock. These
additional shares include the common stock equivalent effect of 25,000,000
shares of Series B Convertible Preferred Stock, 15,764,000 outstanding warrants
and 7,450,000 options. For the year ended December 31, 2008, there were
8,937,966 additional potentially dilutive shares of common stock due primarily
to the effect of outstanding warrants and stock
options.




Recent
Accounting Pronouncements




In April
2009, accounting standards related to “Interim Disclosures about Fair
Value of Financial Instruments” require disclosures about fair value of
financial instruments in interim and annual financial statements. These
standards are effective for periods ending after June 15, 2009. The Company
adopted these standards effective for the quarter ending September 30, 2009. The
adoption did not have an impact on the Company’s financial position or results
of operations.


35




In May
2009, more specific accounting standards related to “Subsequent Events”
established general standards of accounting for and disclosure of events that
occur after the balance sheet date but before financial statements are issued.
The Company adopted these standards for the quarter ending September 30,
2009.





In June
2009, a new accounting standard related to the codification of all accounting
standards was issued. Under the standard, Accounting Standards Codification
(Codification) will become the source of authoritative U.S. generally accepted
accounting principles (GAAP) recognized by the FASB to be applied by
nongovernmental entities. Rules and interpretive releases of the Securities and
Exchange Commission (SEC) under the authority of federal securities laws are
also sources of authoritative GAAP for SEC registrants. On the effective date of
this Statement, the Codification superseded all then-existing non-SEC accounting
and reporting standards. All other non-grandfathered non-SEC accounting
literature not included in the Codification became non-authoritative. This
statement is effective for financial statements issued for interim and annual
periods ending after September 15, 2009. In the Financial Accounting Standards
Board’s (“FASB”) view, the issuance of this Statement and the Codification will
not change GAAP, except for certain nonpublic nongovernmental entities. The
Company does not expect that the adoption of this Statement will have a material
impact on the Company’s financial statements.





Other accounting standards that may
have been issued or proposed by the FASB or other standards-setting bodies are
not expected to have a material impact on the Company’s consolidated financial
statements.





Note 3:
Inventories




Inventories
consisted of the following at December 31, 2009 and 2008. Included in inventory
is an inventory reserve for obsolescence of approximately $100,000 and $0 at
December 31, 2009 and 2008 respectively:


December 31,2009
                
                
                2008Raw
      Materials
                
                $
                175,527
                
                
                $
                205,651Finished
      Goods
                
                
                230,148
                
                
                
                260,230Total
      inventories
                
                $
                405,675
                
                
                $
                465,881




Note 4:
Income Taxes




The
significant components of deferred tax assets as of December 31, 2009 and 2008
are shown below. A valuation allowance has been established to offset the
deferred tax assets, as realization of such assets is uncertain.


Year Ended
                  December 31,
                  2009
                
                
                Year Ended
                  December 31,
                  2008Deferred
      tax assets:Net
      operating loss carryforward
                
                $
                11,180,062
                
                
                $
                10,678,283Research
      and development credits
                
                
                512,515
                
                
                
                634,274Stock
      compensation
                
                
                1,477,485
                
                
                
                1,221,793Inventory
      Reserve
                
                
                34,802
                
                
                
                —Accrued
      liabilities and other
                
                
                45,082
                
                
                
                26,085Total
      deferred tax assets
                
                
                13,249,946
                
                
                
                12,560,435Valuation
      allowance
                
                
                (11,691,089
                )
                
                
                (10,589,131
                )Net
      deferred tax assets
                
                
                1,558,857
                
                
                
                1,971,304Deferred
      tax liabilities:Acquired
      intangibles
                
                
                (73,611
                )
                
                
                (81,348
                )Fixed
      assets
                
                
                (397,293
                )
                
                
                (710,326
                )Patents
                
                
                (1,087,953
                )
                
                
                (1,179,630
                )Luma
      asset acquisition with common stock
                
                
                —
                
                
                
                —Total
      deferred tax liabilities
                
                
                (1,558,857
                )
                
                
                (1,971,304
                )Net
      deferred taxes
                
                $
                —
                
                
                $
                —






36


The
following reconciles the tax provision with the expected provision obtained by
applying statutory rates to pretax income:




Year Ended December 31, 2009
                    
                    Year Ended December 31, 2008Amount
                    
                    % of Pretax
                      Income
                    
                    Amount
                    
                    % of Pretax
                      IncomeIncome
      tax at federal statutory rate
                    
                    $
                    (1,506,000
                    )
                    34.0
                    %
                    $
                    (1,750,000
                    )
                    34.0
                    %State
      tax provision, net of federal tax benefit
                    
                    
                    (259,000
                    )
                    5.8
                    
                    
                    (300,000
                    )
                    5.8Nondeductible
      differences
                    
                    
                    (17,000
                    )
                    0.4
                    
                    
                    28,000
                    
                    (0.5
                    )Tax
      credits
                    
                    
                    41,000
                    
                    (0.9)
                    
                    
                    (55,000
                    )
                    1.1Change
      in valuation allowance
                    
                    
                    1,102,000
                    
                    (24.9
                    )
                    
                    901,000
                    
                    (17.5
                    )Expiration
      of net operating losses
                    
                    
                    593,000
                    
                    (13.4
                    )
                    
                    1,056,000
                    
                    (20.5
                    )Other
                    
                    
                    46,000
                    
                    (1.0
                    )
                    
                    120,000
                    
                    (2.3
                    )Provision
      for income taxes
                    
                    $
                    —
                    
                    0.0
                    %
                    $
                    —
                    
                    0.0
                    %





At
December 31, 2009, the Company had federal net operating loss carry-forwards of
approximately $27,800,000 that expire from 2010 through 2029. During 2009, the
Company had federal net operating losses of approximately $1,540,000
expire.  In addition, the Company had research and development tax
credits of approximately $478,000 that expire from 2010 through 2029. As a
result of previous stock transactions, the Company's ability to utilize its net
operating loss carryforwards to offset future taxable income and utilize future
research and development tax credits is subject to certain limitations under
Section 382 and Section 383 of the Internal Revenue Code due to changes in
equity ownership of the Company.




The
Company has a history of operating losses and, as of yet, has not had any
taxable income. The Company has calculated a deferred tax asset for its tax
credits but offsets the tax asset with a valuation allowance. As a result, the
Company has not realized or recorded any tax benefit related to its tax
credits.





Note 5:
Lease Commitment





The
Company leases its principal facility from an unrelated third party. The
facility consists of approximately 5,080 square feet of office, research and
development, manufacturing, quality testing, and warehouse space. The lease
provides for monthly rental payments of $4,318 and additional shared facility
costs of $972 per month through December 2011. Total commitment under this lease
for 2010 and 2011 is approximately $64,000 each year. For the years ended
December 31, 2009 and 2008, rent expense totaled $80,332 and $97,873,
respectively.





Note 6:
Stock-Based Compensation Plans





The
Option Plan was amended in 2004. The Option Plan provides for the grant of ISOs
to our full-time employees (who may also be Directors) and NSOs to non-employee
directors, consultants, customers, vendors or providers of significant services
and expires on January 30, 2011. The exercise price of any ISO may not be less
than the fair market value of the common stock on the date of grant and the term
shall not exceed ten years. The amount reserved under the Plan shall equal 15%
of the outstanding shares of the Company totaling 10,521,392 at December 31,
2009. At December 31, 2009, the Company had granted 7,450,000 options under the
Plan (5,050,000 of which are exercisable), with 3,071,392 available for future
issuance.





Options
outstanding that have vested and are expected to vest as of December 31, 2009
are as follows:





Number of
                  Shares
                
                Weighted
                  Average
                  Exercise
                  Price
                
                Weighted Average
                  Remaining
                  Contractual Term in
                  Years
                
                Aggregate
                  Intrinsic
                  Value (1)Vested
                5,050,000
                
                $
                0.64
                
                6.97
                
                $
                —Expected
      to vest
                2,400,000
                
                $
                0.25
                
                9.99
                
                
                360,000Total
                7,450,000
                
                
                
                
                
                
                $
                360,000




(1) These
amounts represent the difference, if any, between the exercise price and $0.40,
the closing market price of the Company’s common stock on December 31, 2009 as
quoted on the Over-the-Counter Bulletin Board under the symbol
“SCIE.OB”.





Additional
information with respect to stock option activity is as follows:




37





Outstanding OptionsOptions
                      Available For
                      Grant
                    
                    
                    Plan Options
                      Outstanding
                    
                    
                    Weighted
                      Average
                      Exercise Price
                      Per Share
                    
                    Weighted-Average
                      Remaining
                      Contractual Term
                      (years)
                    
                    Aggregate
                      Intrinsic
                      Value (1)December 31, 2007
                    
                    
                    3,053,942
                    
                    
                    
                    5,795,000
                    
                    
                    $
                    0.70Options
      granted
                    
                    
                    (3,050,000
                    )
                    
                    
                    3,050,000
                    
                    
                    $
                    0.42Options
      exercised
                    
                    
                    20,000
                    
                    
                    
                    (20,000
                    )
                    
                    $
                    0.15Options
      forfeited
                    
                    
                    675,000
                    
                    
                    
                    (675,000
                    )
                    
                    $
                    0.89Additional
      options authorized
                    
                    
                    1,443,098December
      31, 2008
                    
                    
                    2,142,040
                    
                    
                    
                    8,150,000
                    
                    
                    $
                    0.58Options
      granted
                    
                    
                    (1,100,000
                    )
                    
                    
                    1,100,000
                    
                    
                    $
                    0.31Options
      exercised
                    
                    
                    400,000
                    
                    
                    
                    (400,000
                    )
                    
                    $
                    0.15Options
      forfeited
                    
                    
                    1,400,000
                    
                    
                    
                    (1,400,000
                    )
                    
                    $
                    0.71Additional
      options authorized
                    
                    
                    229,352
                    
                    
                    
                    —
                    
                    
                    $December
      31, 2009
                    
                    
                    3,071,392
                    
                    
                    
                    7,450,000
                    
                    
                    $
                    0.54
                    
                    7.71
                    
                    $
                    —Exercisable
      December 31, 2009
                    
                    
                    
                    
                    
                    
                    5,050,000
                    
                    
                    $
                    0.64
                    
                    6.97
                    
                    $
                    —





The total
intrinsic value of options exercised during the years ended December 31, 2009
and 2008 was $160,000 and $13,000, respectively. At December 31, 2009, total
unrecognized estimated employee and director compensation cost related to
non-vested stock options granted prior to that date is $454,476, which is
expected to be recognized over approximately 3 years.




For the
fiscal year ended December 31, 2009, the Company granted stock options to
purchase 400,000 common shares to employees and directors. At the time of grant,
those options were estimated to have an aggregate fair value of approximately
$91,000. For the fiscal year ended December 31, 2008, the Company granted stock
options to purchase 3,050,000 common shares to employees and directors. At the
time of grant, these options were estimated to have an aggregate fair value of
approximately $1,070,000.





Note 7:
Undesignated Capital Stock




The
Company has authorized 40,000,000 of undesignated shares of capital stock with
undesignated par value. The undesignated stock may be issued in one or more
series as determined from time to time by the Board of Directors. Any series
authorized for issuance by the Board of Directors may be senior to the common
stock with respect to any distribution if so designated by the Board of
Directors upon issuance of the shares of that series. The Board of Directors are
granted the express authority to fix by resolution any other designations,
powers, preferences, rights (including voting rights), qualifications,
limitations or restrictions with respect to any particular series created from
the undesignated stock prior to issuance thereof.




Note 8:
Equity Transactions




Fiscal
Year Ended December 31, 2009





Common
Stock




On
January 30, 2009, we entered into a Common Stock Purchase Agreement (the
“Purchase Agreement”) with Fusion Capital Fund II, an Illinois limited liability
company. Under the Purchase Agreement, Fusion Capital is obligated, under
certain conditions, to purchase shares from us in an aggregate amount of $6.0
million from time to time over a twenty-four (24) month period.  Under
the terms of the Purchase Agreement, Fusion Capital has received a commitment
fee consisting of 1,094,017 shares of our common stock.  Also, we will
issue to Fusion Capital an additional 547,009 shares as a commitment fee
pro-rata as we receive the $6.0 million of future funding.  In
addition, in December 2008, we issued 100,000 shares to Fusion Capital as an
expense reimbursement.





Under the
Purchase Agreement and the associated Registration Rights Agreement we are
required to register 13,000,000 common shares comprised of: (1) 1,094,017 shares
which have already been issued, (2) an additional 547,009 shares which we may
issue in the future as a commitment fee pro rata as we receive the $6.0 million
of future funding, (3) 100,000 shares we previously issued to Fusion Capital as
an expense reimbursement and (4) at least 11,558,974 shares which we may sell to
Fusion Capital after a registration statement is declared effective. Under the
Purchase Agreement, we have the right but not the obligation to sell more than
the 13,300,000 shares to Fusion Capital. As of the date hereof, we do not
currently have any plans or intent to sell to Fusion Capital any shares beyond
the 13,300,000 shares offered pursuant to the Purchase
Agreement.  However, if we elect to sell more than the 13,300,000
shares (which we have the right but not the obligation to do), we must first
register under the Securities Act any additional shares we may elect to sell to
Fusion Capital before we can sell such additional shares.  The number
of shares ultimately offered for sale by Fusion Capital is dependent upon the
number of shares purchased by Fusion Capital under the Purchase
Agreement.


38





We do not
have the right to commence any sales of our shares to Fusion Capital until the
SEC has declared effective a registration statement. After the SEC declared
effective such registration statement, which occurred on May 5, 2009, generally
we received the right but not the obligation from time to time to sell our
shares to Fusion Capital in amounts between $25,000 and $1.0 million depending
on certain conditions. We have the right to control the timing and amount of any
sales of our shares to Fusion Capital.  The purchase price of the
shares will be determined based upon the market price of our shares without any
fixed discount at the time of each sale.  Fusion Capital does not have
the right or the obligation to purchase any shares of our common stock on any
business day that the price of our common stock is below $0.15.  There
are no negative covenants, restrictions on future fundings, penalties or
liquidated damages in the Purchase Agreement or the Registration Rights
Agreement. The Purchase Agreement may be terminated by us at any time at our
discretion without any cost to us.  The Purchase Agreement provides
that neither party has the ability to amend the Purchase Agreement and the
obligations of both parties are non-transferable.





In
December 2009, the Company issued 35,000 restricted common shares to a vendor
for services. The fair value of the shares was determined to be $11,200, and the
company recognized expense in the amount of $11,200, based upon the market value
of the stock on the date of issuance.





Series
B Convertible Preferred Stock and Warrants





On June
22, 2009, the Board of Directors designated 25,000,000 of the Company’s
undesignated capital stock as Series B Convertible Preferred Stock (the
“Preferred”) with par value of $0.01 per share. The Preferred is convertible
into an equal number of shares of the Company’s Common Stock based upon an
initial conversion price of $0.20 per share and carries a liquidation preference
of like amount plus declared but unpaid cumulative dividends at December 31,
2009, the total liquidation preference is equal to $5,100,000. At December 31,
2009 there were approximately $100,000 in accumulated, but unpaid dividends. The
Preferred is entitled to receive cumulative dividends in preference to any
dividend which may be declared on the Common Stock at the rate of 8% of the
original issue price. In addition, the Preferred has rights which provide for
(i) dividend payments senior to those with respect to common shares, (ii) voting
rights equal to the number of common shares into which the Preferred is
convertible and (iii) adjustments to the conversion price in the event of stock
dividends, stock splits or other effective stock subdivisions. The Preferred is
subject to automatic conversion in the event of (a) an underwritten public
offering exceeding $10 million in gross proceeds to the Company or, (b) the
approval of 67% of the Preferred holders or (c) the underlying conversion shares
becoming freely tradable and the average daily trading volume of the underlying
stock being not less than 50,000, nor the average closing price of the
underlying stock being not less than the conversion price then in effect for 10
consecutive trading days.





From May
through December 2009, as a part of a Units offering, the Company sold
25,000,000 shares of its Preferred to accredited investors for an aggregate
consideration of $5,000,000. The Company received net cash proceeds of
$4,308,446 after the payment of finders’ fees and expenses of $691,554. In
addition, the Company issued five-year warrants to purchase 12,500,000
additional shares of Common Stock at an initial exercise price of $0.30 per
share and 2,500,000 agent warrants at an initial exercise price of $0.35 per
share. The fair-value of the agent warrants, as determined using the
Black-Scholes option pricing model at the time of issuance, was approximately
$850,000. The convertible feature of the Preferred and the terms of the warrants
provide for a rate of conversion or exercise that was below market value at
issuance. Such feature, as it specifically relates to the convertible feature of
the Preferred, is characterized as a “Beneficial Conversion Feature” (“BCF”).
Pursuant to existing accounting standards, the estimated relative fair values of
the BCF and the warrants, in approximate amounts of $2,592,000 and $2,349,000,
respectively, were calculated. The value of the BCF was determined utilizing an
intrinsic value method with the fair value of the warrants determined using the
Black-Scholes option-pricing model at the date of issuance. The warrant fair
values were determined assuming a five-year term, stock volatility of between
approximately 125% and 122% and risk-free interest rates of between 1.98% and
2.74%. The stand-alone fair value of the BCF was then determined to be higher
than the remaining proceeds received and, accordingly, the value assigned to the
BCF was limited to the gross proceeds received from the offering net of the fair
value of the warrants. Per the guidance of accounting standards, the value of
the BCF is treated as a deemed dividend to the Preferred stockholders and, due
to the potential immediate convertibility of the Preferred stock at issuance,
this value is recorded as an increase to both additional-paid-in-capital and
accumulated deficit at the time of issuance.




Fiscal
Year Ended December 31, 2008




Common
Stock




In
December 2008, the Company issued 100,000 restricted common shares to Fusion
Capital in payment of expenses related to a proposed financing. The fair value
of the shares was determined to be, and the company capitalized an amount of
$33,000, based upon the market value of the stock on the date of
issuance.




In June
2008, the Company issued 10,000 restricted common shares to a vendor for
services. The fair value of the shares was determined to be $7,500, and the
company recognized expense in the amount of $7,500, based upon the market value
of the stock on the date of issuance.




In May
2008, the Company issued 121,470 shares of Common Stock to accredited investors
at a price of $0.70 per share for an aggregate consideration of $85,000 in the
final closing tranche of the Financing. The Company received net cash proceeds
of approximately $68,000 after placement agent commissions and expenses of
approximately $17,000.


39




In
February 2008, the Company issued 615,386 shares of Common Stock to accredited
investors at a price of $0.70 per share for an aggregate consideration of
$430,770. The Company received net cash proceeds of approximately $377,000 after
placement agent commissions and expenses of $42,770.




Series
A Convertible Preferred Stock




In March
2008, the holder of 2,000,000 shares of Series A Convertible Preferred stock
converted his shares into 8,000,000 shares of restricted Common Stock. The
Series A Convertible Preferred Stock was converted into Common Stock at a
conversion price of $0.125 per share. The Company received no proceeds as a
result of the transaction.




Series
A Convertible Preferred Stock Warrants




In
December 2008 the holders of 71,250 of the Company’s Series A Preferred Warrants
affected a cashless exercise of their warrants in exchange for 147,981
restricted common shares. The Company received no proceeds as a result of the
exercise.




In May
2008 the holders of 153,750 of the Company’s Series A Preferred Warrants
affected a cashless exercise of their warrants in exchange for 521,249
restricted common shares. The Company received no proceeds as a result of the
exercise.




In April
2008 a holder of 25,000 of the Company’s Series A Preferred Warrants affected a
cashless exercise of his warrants in exchange for 84,568 restricted common
shares. The Company received no proceeds as a result of the
exercise.




Common
Stock Purchase Warrants




In May
2008, as additional consideration associated with a private placement of Common
Stock, the Company issued 73,681 five-year cashless warrants to purchase an
equal number of common shares at $0.80 per share to Advanced Equities, Inc., the
placement agent associated with the placement. The Company is obligated to
reserve 73,681 common shares under these warrants and the shares underlying the
warrants are subject to a registration rights agreement




Stock
Options




In May
2008, 20,000 stock options held by an employee were exercised. The Company
received net proceeds of $3,000 as a result of the exercise.




Note 9:
Related Party Transactions




On July
21, 2009, the Board of Directors approved the grant of 400,000 options to a
non-employee director. The terms are as follows: 1/3 of the grant will vest
after one year and the remaining options will vest an additional 1/3 over each
of the next three years.  The options were granted at the closing
price of our Common Stock on the date of grant.




Note 10:
License Agreement




The
Company is the exclusive licensee through the Massachusetts General Hospital of
US Patent number 5,843,000 entitled, “Optical Biopsy Forceps and Method of
Diagnosing Tissue” and a pending international patent application. This license
agreement requires a royalty be paid on sales of the patent on products using
claims described within the patent under the license. For the fiscal year
ended December 31, 2009, revenues have been generated from sales of
products using this patent and royalties in an amount of $1,260 have been
paid.





Note 11:
Fair Value of Long Lived Assets





The Fair
Value Measurements and Disclosures Topic of the FASB Accounting Standards
Codification defines fair value establishes a framework for measuring fair value
and requires disclosure of fair value measurements, Effective January 1, 2009,
the Company adopted the portion of the Topic which requires disclosure of
nonfinancial assets and nonfinancial liabilities that are recognized or
disclosed at fair value on a nonrecurring basis. The fair value hierarchy set
forth in the Topic is as follows:





Level
1:   Quoted prices (unadjusted) for identical assets or
liabilities in active markets that the entity has the ability to access as of
the measurement date.





Level
2:   Significant other observable inputs other than Level 1
prices such as quoted prices for similar assets or liabilities; quoted prices in
markets that are not active; or other inputs that are observable or can be
corroborated by observable market data.





Level
3:   Significant unobservable inputs that reflect a reporting
entity’s own assumptions about the assumptions that market participants would
use in pricing an asset or liability.





A
description of the valuation methodologies used for assets and liabilities
measured at fair value, as well as the general classification of such
instruments pursuant to the valuation hierarchy, is set forth
below.


40




The
Company does not record long lived assets at fair value on a recurring basis.
However, from time to time, a long lived asset is considered impaired and the
asset value is written down. The impairment is based on management’s estimate of
future cash flows from these assets. Adjustments are based on unobservable
inputs, the resulting fair value measurement is categorized as a level 3
measurement. Total LUMA equipment of approximately $1,786,000 was valued under
this level as of December 31, 2009.





Note 12:
Subsequent Events





Common
Stock





In
January 2010, the Board approved the issuance of 249,213 shares of Common Stock
for payment of accrued dividends related to the Company’s outstanding
Convertible Preferred Stock (“Preferred”). The Preferred accumulated a dividend
equal to $99,685 on December 31, 2009. As per the terms of the Series B
Preferred the Company may pay the dividend either in cash or Common Stock as
determined by the Board of Directors.




From
January through March 2010, the Company issued 105,000 restricted common shares
to a vendor for services. The fair value of the shares was determined to be
$39,550, and the company recognized expense in the amount of $39,550, based upon
the market value of the stock on the date of issuance.




In
February and March 2010, holders of 19,600,000  Preferred converted
their Preferred into a like number of unrestricted shares of Common Stock as per
the terms of the Preferred.




Subsequent
events have been evaluated through the date financial statements are filed with
the Securities and Exchange Commission.




ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.





None




ITEM
9A(T).CONTROLS AND PROCEDURES.





Evaluation
of Disclosure Controls and Procedures





Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we evaluated the effectiveness of
the design and operation of our disclosure controls and procedures (as defined
in the Exchange Act Rule 13a-15(e)) as of the end of the period covered by this
report (the “Evaluation Date”). We reviewed in particular whether the
information required to be disclosed is recorded, processed, summarized and
reported  appropriately within the required time periods and was
accumulated and communicated to management in a timely manner. Based on that
evaluation, the Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures are effective to provide reasonable
assurance that:





·
            Financial
      records are maintained in reasonable detail to accurately and fairly
      reflect the transactions and dispositions of the
  Company;·
            Transactions
      are recorded as necessary to permit preparation of financial statements in
      accordance with generally accepted accounting principles, and that
      receipts and expenditures are being made in accordance with authorizations
      of management and directors of the Company; and·
            Internal
      controls provide reasonable assurance to prevent or detect in a timely
      manner unauthorized acquisitions, use or dispositions of the Company that
      could have a material effect on the financial
  statements





Evaluation
of Internal Control over Financial Reporting





Management
is responsible for establishing and maintaining adequate internal control over
financial reporting, as such term is defined in Exchange Act Rule 13a-15(f). The
Company’s internal control over financial reporting includes those policies and
procedures that (i) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the
assets of the Company; (ii) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with authorization of management and directors of the Company; and
(iii) provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the Company’s assets that could
have a material effect on the financial statements.




41


Under
supervision and with the participation of management, including our principal
executive officer and principal financial officer, we conducted an evaluation of
the effectiveness of our internal control over financial reporting based on the
framework in Internal
Control-Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Based on our evaluation under the
framework within the Internal
Control-Integrated Framework, management concluded that our internal
control over financial reporting was effective as of December 31,
2009.





Management’s
assessment of the effectiveness of our internal control over financial reporting
as of December 31, 2009 has not been attested to by McGladrey & Pullen, LLP
the Company’s independent registered public accounting firm as stated in their
report which is included herein pursuant to temporary rules of the Securities
and Exchange Commission that permit the Company to provide only management’s
report within this annual report.





Changes
in Internal Financial Controls





Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we evaluated any changes to our
internal controls over financial reporting which may have occurred during the
quarter ended December 31, 2009. Based on that evaluation, the Chief Executive
Officer and Chief Financial Officer concluded that there were no changes in the
Company’s internal controls over financial reporting during the quarter ended
December 31, 2009 which have materially affected, or are likely to materially
affect our internal control over financial reporting.





ITEM 9B.
OTHER INFORMATION.





None





PART
III





ITEM 10.
DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE.




The
following information is provided with respect to the directors and officers of
the Company:





Name
            
            Age
            
            Director/Officer SinceJim Hitchin,
      Chairman, President and
      CEO
            
            67
            
            2004Jim
      Dorst, Chief Financial
      Officer
            
            55
            
            2007Mark
      McWilliams, Director
            
            53
            
            2004Stanley
      Pappelbaum, M.D., Director
            
            72
            
            2006Chester
      E. Sievert, Director
            
            58
            
            2004F.
      Duwaine Townsen, Director
            
            76
            
            2009





Jim Hitchin,
Chairman, President and CEO joined SpectraScience in January 2004 as part
of the acquisition team. For the previous 15 years, he was the founder, CEO and
Chairman of Infrasonics, Inc., a medical device company in the respiratory care
field. Infrasonics was venture funded and completed a successful initial public
offering. Mr. Hitchin served as Chairman, President and CEO of Infrasonics
during its 15 years as a public company. Infrasonics was the first in its market
to have ISO 9001 and the CE Mark for fourteen 510(k) and two PMA products.
Infrasonics revenue growth was at a compound rate of 62% during its fifteen-year
life before being sold to a competitor for 2.5 times revenue. In previous
companies, he was COO of a public energy company and the VP, General Manager of
a public oceanographic engineering firm. Mr. Hitchin has extensive experience in
all phases of manufacturing and company operations, in particular, sales and
marketing of medical devices. He graduated from San Diego State University with
a degree in Physics.





Jim Dorst, Vice President of Finance
and CFO joined the Company in December 2007. Mr. Dorst brings to the
Company over 20 years of senior management experience in finance, operations,
planning and business transactions. Prior to joining SpectraScience, Mr. Dorst
was Chief Financial Officer of Aethlon Medical, Inc., a public medical device
development company. Before joining Aethlon, Mr. Dorst was Vice President of
Finance and Operations for Verdisoft Corporation, a developmental-stage
mobile-software developer acquired by Yahoo, Inc. Previously, he held executive
positions as SVP of Finance and Administration at SeeCommerce, COO/CFO of Omnis
Technology Corp and CFO / SVP of Information Technology at Savoir Technology
Group, Inc. (acquired by Avnet, Inc.). Mr. Dorst practiced as a Certified Public
Accountant with Coopers & Lybrand (PricewaterhouseCoopers) and holds an MS
in Accounting and a BS in Finance from the University of Oregon.




42


Mark McWilliams,
Director. Since June 2007 Mr. McWilliams has served as the CEO of
Medipacs, Inc a development stage infusion pump company. Prior to that, from
December 2003 to November 2005 he was Director of Cell Imaging and Analysis at
Beckman Coulter after the recent sale of Q3DM to Beckman in December 2003. He
was President and Chief Executive Officer and Director of Q3DM, from October
2001 to December 2003, a life-sciences startup that raised several angel and
venture capital funding rounds that was acquired by Beckman Coulter. Previously,
he was founder and COO of Medication Delivery Devices (“MDD”), an alternate care
infusion systems company that was acquired by Baxter Healthcare in 1996. Mr.
McWilliams served as a VP of Research and Development at Baxter Healthcare for
three years following the sale of MDD. Prior to MDD, he served as Product
Development Manager at the founding of Block Medical where he was responsible
for bringing the company’s first two FDA approved products rapidly to market.
Block was sold to Hillenbrand Industries in 1991. He previously worked for
Hughes Aircraft, Vacuum General and Martin Marietta. Mr. McWilliams has
expertise in managing and growing small technology companies and has a strong
network of contacts within the medical devices industry. He earned his MSME from
the Massachusetts Institute of Technology, his BSME from Northeastern University
and holds eight utility patents.





Stanley J.
Pappelbaum M.D., Director. Dr. Pappelbaum has been Managing Partner of
Pappelbaum, Turner & Associates, a national healthcare consultancy company
that advises hospital, medical group, health insurance, and governmental
healthcare clients since 2000. Dr. Pappelbaum joined Scripps hospital in 1996 as
Chief Transformational Officer in charge of creating and implementing Scripps’
strategic vision of the future. In 1997, he was promoted to Executive Vice
President and Chief Operating Officer and, in 1999, he was promoted to President
and Chief Executive Officer when the hospital reached annual revenues of over $1
billion. From 1985 to 1995, he was the managing partner of Professional Health
Consulting Group, a national company of physician executives who analyzed and
managed change for complex not-for-profit healthcare systems clients throughout
the United States. From 1969 to 1984, Dr. Pappelbaum taught and practiced
Pediatric Cardiology at the University of California, San Diego and at San Diego
Children’s Hospital, where he was Chief of Pediatric Cardiology from 1972
to1978. Dr. Pappelbaum completed his undergraduate work at McGill University in
Montreal and received his medical degree from the University of British Columbia
Faculty of Medicine in Vancouver. He completed his residency in pediatric
medicine at Montreal Children’s Hospital of McGill University and did graduate
studies in cardiovascular physiology and a fellowship in pediatric cardiology at
the University of California, Los Angeles. He also was awarded an Alfred P.
Sloan Fellowship at the Massachusetts Institute of Technology where he earned a
Master's degree in management (health option). Dr. Pappelbaum has an intimate
knowledge of the healthcare industry and is familiar with recent changes in the
healthcare environment.





Chester E.
Sievert, Jr., Director. Mr. Sievert has been President of Advanced
Photodynamic Technologies since January 2003. He previously worked at
SpectraScience as a consultant in June 1996, and subsequently held various
executive positions. Mr. Sievert served as Chairman of the Board of
SpectraScience beginning in June 1999. He served as President from March 1998,
and Chief Executive Officer from January 1999 until December 2001. He then
became Executive Vice President of Technology and Chairman of the Board until
September 2002. Prior to joining SpectraScience, Mr. Sievert was a founder and
President of two medical product companies; ReTech, Inc. from 1980 to 1986; and
FlexMedics Corporation from 1986 to 1995. Both Companies were sold to American
Endoscopy, Inc. and Phillips Plastics Corporation, respectively. As a former
Senior Research Health Scientist on staff at the University of Minnesota Medical
School and the Veterans Administration Medical Center, Mr. Sievert has published
more than 50 medical journal articles in the fields of gastroenterology,
endoscopy and fiber optics. He has also been awarded eight United States and
International patents. Mr. Sievert has a Bachelor of Science Degree in
Comparative Physiology from the University of Minnesota.Mr. Sievert has
significant experience in the application of light based and fluorescence
technologies in the medical field. He also has significant management experience
and a legacy understanding of the Company.





F. Duwaine
Townsen, Director.   Mr.
Townsen co-founded and is the Managing Partner of EndPoint Late-Stage Fund of
San Diego. This fund invested exclusively in late-stage life science companies.
Mr. Townsen co-founded the Ventana Growth Funds in 1982 and served as the
group’s Managing Partner directing investments in early and middle stage
life-science, high-technology and telecommunications companies. Prior to this,
Mr. Townsen was the CEO and Chairman of Kay Laboratories, Inc., a medical device
company, where he led the company through a successful IPO in 1978 and
subsequent sale to American Hospital Supply Corporation in 1981. Following his
public accounting experience, Mr. Townsen became a founder and Chief Financial
Officer of Oceanographic Engineering Corporation and guided the company to
profitability and its sale to Dillingham Corporation in 1967.  Mr.
Townsen serves as a director on the board of Sequal Technologies, a privately
held high-technology company and has held numerous directorships at private and
public companies, some of which included Agouron Pharmaceuticals, Inc.,
Brooktree Corporation, Cymer, Inc. and Maxim Pharmaceuticals,
Inc.  Mr. Townsen began his career with Arthur Young & Co. after
graduating from San Diego State University. Mr. Towsen has specific public
accounting environment and public markets experience. He also had deep expertise
related to corporate governance and fiduciary responsibility
issues.





Our Board
of Directors has the responsibility for establishing broad corporate policies
and for overseeing our overall performance. Members of the Board are kept
informed of our business activities through discussions with the CEO and other
officers, by reviewing analyses and reports sent to them, and by participating
in Board and committee meetings. Our bylaws provide that each of the directors
serves for a term that extends until resignation or replacement.





Compensation of
Directors.





The
Company does not pay directors for Board of Directors’ meetings or committee
meetings attended, but reimburses each such director for reasonable travel and
out-of-pocket expenses for attendance at these meetings.




43


Pursuant
to the SpectraScience, Inc. Amended 2001 Stock Option Plan, non-employee
directors McWilliams, Mulford and Sievert were granted non-qualified stock
options to purchase 400,000, 400,000 and 300,000 shares of Common Stock,
respectively, on July 26, 2004 at an exercise price of $0.15 per share. Dr.
Pappelbaum joined the Board on June 2006 and was granted a non-qualified stock
option to purchase 400,000 shares of Common Stock at an exercise price of $1.09
per share. Mr. Pappajohn joined the Board in June 2007 and was granted a
non-qualified stock option to purchase 400,000 shares of Common Stock at $1.10
per share. Governor Tommy Thompson joined the Board on September 20, 2007 and
was granted a non-qualified stock option to purchase 400,000 shares of Common
Stock at an exercise price of $0.75 per share. In addition, on December 4, 2009,
Thompson was granted a non-qualified stock option to purchase 400,000 shares of
Common Stock at an exercise price of $0.34 per share. On November 7, 2008
directors McWilliams, Mulford, Pappelbaum and Sievert were each granted
non-qualified stock options to purchase 400,000 shares of common stock at an
exercise price of $0.38 per share. Mr. Townsen was granted a non-qualified stock
option to purchase 400,000 shares of Common Stock at an exercise price of $0.27
per share on July 20, 2009. The exercise prices of the options were based on the
prevailing market price (defined as the closing price) of the Common Stock on
the date of grant.





The
options granted to employee and non-employee directors under the Amended 2001
Stock Option Plan expire ten years from the date of grant (subject to earlier
termination in the event of death or termination), are not transferable (except
by will or the laws of descent and distribution), and become exercisable in
three equal annual installments commencing on the date of grant except for the
November 7, 2008, July 20, 2009 and December 4, 2009 grants which commence
vesting in three equal annual amounts one year from the date of
grant.





The
following table shows the fair value of the compensation earned by each of our
non-employee directors who received stock option grants during the year ended
December 31, 2009:




DIRECTOR
COMPENSATION





Name
                  
                  Option Awards
                    ($)(3)
                  
                  
                  TotalF. Duwaine Townsen(1)(2)
                  
                  $
                  91,120
                  (2)
                  
                  $
                  91,120





(1)
            The
      aggregate number of stock awards and options awards issued and outstanding
      as of December 31, 2009 are 0 and 400,000.(2)
            On
      July 20, 2009, Mr. Townsen was granted a non-qualified stock option to
      purchase 400,000 shares of Common Stock at an exercise price of $0.27 per
      share. The option vests one-third on each anniversary date from initial
      grant and will be fully vested on July 20, 2012. The $91,120 represents
      the fair value of the stock option as determined on the date of
      grant.(3)
            The
      value of each option award is the grant date fair value as determined
      under FASB ASC Topic 718, Compensation – Stock
      Compensation,or ASC 718.




Code of Ethics. The Company
has adopted a code of ethics applicable to its chief executive officer and
senior financial officer. The code is available at no charge by request to the
Company in writing, to the attention of the CFO. Additionally, the code is filed
with the Securities and Exchange Commission as an exhibit to the Company’s
Report on Form 10-KSB for the fiscal year ended December 31, 2005, and is
available at the SEC website (www.sec.gov ).




Audit Committee. The Audit
Committee of the Board of Directors is comprised of three non-employee
directors; F Duwaine Townsen, Mark McWilliams and Dr. Stanley Pappelbaum. All
members are independent as defined under the rules of The Nasdaq Stock Market.
The Audit Committee has Duwaine Townsen, Chairman, serving as an independent
director and financial expert.




ITEM 11.
EXECUTIVE COMPENSATION.




Summary
Compensation Table.




Name
      and Principal Position
                          
                          Year
                          
                          Salary
                            ($)
                          
                          
                          Total
                            ($)Jim Hitchin -(1)
                          
                          2009
                          
                          $
                          88,929
                          
                          
                          $
                          88,929Chairman,
      President and CEO
                          
                          2008
                          
                          $
                          161,915
                          
                          
                          $
                          161,915Jim Dorst – CFO(2)
                          
                          2009
                          
                          $
                          160,101
                          
                          
                          $
                          160,1012008
                          
                          $
                          152,885
                          
                          
                          
                          152,885





(1)
            Mr.
      Hitchin is the Company’s Chairman, President and CEO. He does not have a
      written or unwritten employment agreement and his salary is not dependent
      on performance targets, goals or any other conditions. Also he is not
      subject to severance and change of control arrangements. Mr. Hitchin
      received no stock option grants in 2009 or 2008.(2)
            Mr.
      Dorst became the Company’s Vice President of Finance and Chief Financial
      Officer on December 3, 2007. He does not have a written employment
      agreement, his salary is not dependent on performance targets, goals or
      other conditions and he is not subject to any severance or change in
      control arrangements. Mr. Dorst received no stock option grants in 2009 or
      2008.





Pension Benefits. The Company
does not have a pension benefit plan.




44





Nonqualified Deferred
Compensation. There was no nonqualified deferred compensation in fiscal
year 2009 to officers of the Company.




Grants of Plan-Based Awards, Option
Exercises and Stock Vested. The following table describes the outstanding
stock option grants to executive officers and required additional individuals at
fiscal year end. There are no Stock Awards issued or outstanding.





Outstanding Equity Awards at Fiscal Year End
                    Options AwardsName
                  
                  Number of
                    Securities
                    Underlying
                    Unexercised
                    Options (#)
                    Exercisable
                  
                  Number of Securities
                    Underlying
                    Unexercised Options
                    (#) Unexercisable
                  
                  Equity
                    Incentive Plan
                    Awards:
                    Number of
                    Securities
                    Underlying
                    Unexercised
                    Unearned Options
                    (#)
                  
                  Option
                    Exercise
                    Price
                    ($)
                  
                  Option
                    Expiration DateJim Hitchin
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —Jim
      Dorst
                  
                  
                  400,000
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  $
                  0.90
                  
                  
                  
                  09/07/17





ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
SHAREHOLDER MATTERS.





Summary
of Securities Authorized for Issuance Under Equity Compensation
Plans





The
following table sets forth December 31, 2009 information on our equity
compensation plans in effect as of that date:





EQUITY
COMPENSATION PLAN INFORMATION


(a)
                    
                    (b)
                    
                    (c)Plan category
                    
                    Number of
                      securities to be
                      issued upon
                      exercise of
                      outstanding
                      options, warrants
                      and rights (1)
                    
                    Weighted-average
                      exercise price of
                      outstanding options,
                      warrants and rights
                    
                    Number of
                      securities
                      remaining
                      available for
                      future issuance
                      under equity
                      compensation
                      plans (excluding
                      securities
                      reflected in
                      column (a))Equity
      compensation plans approved by security holders
                    
                    7,450,000
                    
                    $
                    0.54
                    
                    3,071,392Equity
      compensation plans not approved by security holders
                    
                    —
                    
                    
                    —
                    
                    —Totals
                    
                    7,450,000
                    
                    $
                    0.54
                    
                    3,071,392





(1) Net
of equity instruments forfeited, exercised or expired.





2001
Amended Stock Option Plan





Our 2001
Amended Stock Option Plan (the "Option Plan") provides for the grant of
incentive stock options (ISOs") to our employees (who may also be directors) and
nonqualified stock options ("NSOs") to non-employee directors, consultants,
customers, vendors or providers of significant services. The Option plan expires
on January 30, 2011. The exercise price of any ISO may not be less than the fair
market value of the common stock on the date of grant and the term shall not
exceed ten years. The amount reserved under the Option Plan equals 15% of the
outstanding shares of the Company totaling 10,521,392 at December 31, 2009. At
December 31, 2009, we had had option grants outstanding for 7,450,000 common
shares under the Plan, with 3,071,392 available for future
issuance.





The
Company’s Option Plan provides that the number of shares of common stock
available for issuance under the plan shall always equal 15% of the number of
shares of common stock of the Company issued and outstanding.




45




OWNERSHIP OF COMMON
STOCK




The
following table shows as of March 26, 2010, the stock ownership of (i) all
persons known by us to be beneficial owners of more than five percent of our
outstanding shares of Common Stock, (ii) each director and each nominee for
election as a director, (iii) the Named Executive Officers (as defined below
under the caption “Executive Compensation”), and (iv) all current directors and
executive officers as a group:





Beneficial
ownership of the Common Stock is determined in accordance with the rules of the
SEC and includes any shares of Common Stock over which a person exercises shared
or sole voting or investment powers, or of which a person has a right to acquire
ownership at any time within 60 days of March 26, 2010. Except as otherwise
indicated, and subject to applicable community property laws, the persons named
in this table have sole voting and investment power with respect to all shares
of Common Stock held by them. Applicable percentage ownership in the following
table is based on 89,912,615 shares of Common Stock outstanding as of March 26,
2010, plus for each individual, any securities that individual has the right to
acquire within 60 days of March 26, 2010.





Unless
otherwise indicated below, the address of each principal shareholder is c/o
SpectraScience, Inc., 11568-11 Sorrento Valley Road, San Diego, California
92121.


Beneficial Owner
                
                Amount and Nature
                  of Beneficial
                  Ownership(1)
                
                
                Percent
                  of
                  ClassJim Hitchin(2)(3)
                
                
                8,851,149
                
                
                
                10
                %EuclidSR Partners,
      LP(4)
                
                
                8,776,371
                
                
                
                10
                %Chester E. Sievert(3)(5)
                
                
                633,333
                
                
                
                1
                %Mark McWilliams(3)(6)
                
                
                741,666
                
                
                
                1
                %Stanley Pappelbaum M.D.(3)(6)
                
                
                583,000
                
                
                
                *F. Duwaine Townsen(3)
                
                
                —
                
                
                
                *Jim Dorst(2)(7)
                
                
                400,000
                
                
                
                *Directors
      and executive officers, as a group (six persons)
                
                
                11,209,148
                
                
                
                12
                %





*
            Less
      than 1%(1)
            Beneficial
      ownership is determined in accordance with Rule 13d-3(a) of the Securities
      Exchange Act of 1934 and generally includes voting or investment power
      with respect to securities. Except as indicated by footnotes and subject
      to community property laws, where applicable, the person named above has
      sole voting and investment power with respect to all shares of the Common
      Stock shown as beneficially owned by him or her.(2)
            Executive
      Officer(3)
            Director(4)
            EuclidSR
      Partners, LP owns 6,143,404 shares of Common Stock and is affiliated by
      common control with EuclidSR Biotechnology Partners, which together own
      8,776,371 shares. The business address for all Euclid affiliated entities
      is 45 Rockefeller Plaza, Suite 3240, New York, New York
    10111.(5)
            Includes
      433,333 shares which may be acquired upon exercise of options which are
      currently exercisable or which become exercisable within 60 days following
      the date of this report.(6)
            Includes
      533,333 shares which may be acquired upon exercise of options which are
      currently exercisable or which become exercisable within 60 days following
      the date of this report.(7)
            Includes
      400,000 shares which may be acquired upon exercise of options which are
      currently exercisable or which become exercisable within 60 days following
      the date of this report.


46




ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE.




Related
Party Transactions




There
have been no transactions during the last two fiscal years to which we have been
a party in which the amount involved exceeded $120,000 and in which any of our
executive officers, directors or beneficial holders of more than 5% of our
capital stock had or will have a direct or indirect material
interest.




Director
Independence




Other
than Mr. Hitchin, the remaining directors of the Company are independent in that
they have no relationship to the corporation that may interfere with the
exercise of their independence from management and the Company. No independent
director has a business or family relationship with another director to the best
of management’s knowledge. The Audit, Nominating and Compensation Committees
consist of Mr. Townsen (Chair), Mr. McWilliams and Dr. Pappelbaum.




The
Company has determined that its non-employee directors are independent under
NASDAQ Rule 5605(a)(2).




ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES.




Policy
on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of
Independent Auditor




Our audit
committee of the Board of Directors is responsible for pre-approving all audits
and permitted non-audit services to be performed for us by our independent
auditor.




Independent Public Accountants’
Fees.  The firm of McGladrey & Pullen LLP, independent
public accountants, audited our financial statements for the year ended December
31, 2009 and 2008.




The
following table presents fees for professional services rendered for the two
most recent fiscal years.





Year Ended
                    December 31,
                    2009
                  
                  
                  Year Ended
                    December 31,
                    2008Audit fees(1)
                  
                  $
                  122,050
                  
                  
                  $
                  104,000Audit-related fees(
                  
                  
                  —
                  
                  
                  
                  —Tax
      fees
                  
                  
                  —
                  
                  
                  
                  —Tax
      compliance fees
                  
                  
                  —
                  
                  
                  
                  —Other
                  
                  
                  —
                  
                  
                  
                  —$
                  122,050
                  
                  
                  $
                  104,000





(1)
            Audit
      fees include fees billed and expected to be billed for the fiscal year
      ended December 31, 2009 and fees billed and expected to be billed for
      professional services rendered for the audit of our annual financial
      statements for that period, the review of our financial statements
      included in our reports on Form 10-Q, services in connection with
      registration statements filed with the SEC, and accounting consultations
      necessary for the rendering of an opinion on our financial
      statements.




Our Audit
Committee must pre-approve all audit services, engagement fees and terms, and
all permitted non-audit engagements, subject to the de minimus exceptions
permitted pursuant to the Securities Exchange Act of 1934.




47




PART
IV




ITEM 15.
EXHIBITS, FINANCIAL STATEMENT SCHEDULES





(a)   Documents
filed as part of this report.





(1)
              Financial
      Statements. The following financial statements are included in Part II,
      Item 8 of this Annual  Report on Form
  10-K:





Report
      of Independent Registered Public Accounting FirmConsolidated
      Balance Sheets as of December 31, 2009 and 2008Consolidated
      Statements of Operations for the years ended December 31, 2009 and
      2008Consolidated
      Statements of Shareholders’ Equity from December 31, 2007 to December 31,
      2009Consolidated
      Statements of Cash Flows for the years ended December 31, 2009 and
      2008Notes
      to Consolidated Financial
Statements





(2)
            Financial
      Statement Schedules. The following consolidated financial statement
      schedules are included in Item 8: Not
  applicable.





(3)
            Exhibits.
      See “Exhibit Index to Form 10-K” immediately following the signature page
      of this Form 10-K for a description of the documents that are filed as
      Exhibits to this report or incorporated by reference
    herein.


48




SIGNATURES




Pursuant
to the requirements of Sections 13 and 15(d) of the Securities Exchange Act of
1934, as amended, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.




SpectraScience,
      Inc.
              (Registrant)Date:
      March 31, 2010
            By:
            /s/
        James HitchinJames
      Hitchin- Chairman,President, Secretary, and
              Chief
      Executive Officer




Pursuant
to the requirements of the Securities Exchange Act of 1934, as amended, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.


/s/
      James HitchinJames
      Hitchin
            
            Date:
      March 31, 2010Chairman,
      President, Secretary, and Chief Executive Officer
              (Principal
      Executive Officer)/s/
      James DorstJames
      Dorst
            
            Date:
      March 31, 2010Chief
      Financial Officer
              (Principal
      Financial and Accounting Officer)/s/
      Mark D. McWilliamsMark
      D. McWilliams
            
            Date:
      March 31, 2010Director/s/
      Stanley J. PappelbaumStanley
      J. Pappelbaum
            
            Date:
      March 31, 2010Director/s/
      Chester E. SievertChester
      E. Sievert, Jr.
            
            Date:
      March 31, 2010Director/s/
      Duwaine TownsenDuwaine
      Townsen
            
            Date:
      March 31, 2010Director




49




SPECTRASCIENCE,
INC.




EXHIBIT
INDEX FOR




FORM 10-K
FOR FISCAL YEAR 2009




Exhibit No.
            
            Description2.1
            
            Luma
      Acquisition Agreement (1)3.1
            
            Amended
      and Restated Articles of Incorporation (2)3.2
            
            Amended
      Bylaws (3)4.1
            
            Certificate
      of Designation of the Relative Rights and Preferences of the Series A
      Preferred Stock (4)4.2
            
            Warrant
      to Purchase Series A Preferred Stock of SpectraScience, Inc.
      (5)4.3
            
            Common
      Stock Purchase Warrant issued to Placement Agent (6)4.4
            
            Certificate
      of Designation of Rights and Preferences of Series B Preferred stock of
      SpectraScience, Inc. (7)4.5
            
            Form
      of Warrant to Purchase Common Stock of SpectraScience, Inc. issued to
      Holders of Series B Preferred Stock (8)10.1
            
            Common
      Stock Purchase Agreement dated as of January 30, 2009, by and
      between
              SpectraScience,
      Inc. and Fusion Capital Fund II, LLC (9)10.2
            
            Registration
      Rights Agreement dated as of January 30, 2009, by and between
      SpectraScience, Inc. and Fusion Capital Fund II, LLC.
  (10)10.3*
            
            Amended
      2001 Stock Plan (11)10.4*
            
            Form
      of Directors’ Option Agreement (12)21
            
            Subsidiaries
      of the registrant – Luma Imaging Corporation23.1
            
            Consent
      of Independent Registered Public Accounting Firm – McGladrey & Pullen
      LLP31.1
            
            Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002




50





31.2
            
            Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 200232.1
            
            Certification
      of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 200232.2
            
            Certification
      of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002




*
            Denotes
      management compensatory plan or contract.(1)
            Incorporated
      by reference to exhibit 2.1 to the Company’s Report on Form 8-K filed on
      November 13, 2007.(2)
            Incorporated
      by reference to exhibit 3.3 to the Company’s Report on Form 10-Q for the
      quarter ended September 30, 2009, filed on November 16,
    2009.(3)
            Incorporated
      by reference to exhibit 3.2 to the Company’s Registration Statement on
      Form S-1 filed on April 30, 2009(4)
            Incorporated
      by reference to exhibit 4.1 to the Company’s Report on Form 10-QSB for the
      quarter ended June 30, 2007, filed on August 14, 2007.(5)
            Incorporated
      by reference to exhibit 4.2 to the Company’s Report on Form 10-QSB for the
      quarter ended June 30, 2007, filed on August 14, 2007.(6)
            Incorporated
      by reference to exhibit 4.3 to the Company’s Report on Form 10-KSB for the
      fiscal year ended December 31, 2005, filed on March 31,
    2008.(7)
            Incorporated
      by reference to exhibit 4.4 to the Company’s Report on Form 8-K filed on
      November 6, 2009(8)
            Incorporated
      by reference to exhibit 4.5 to the Company’s Report on Form 8-K filed on
      November 6, 2009(9)
            Incorporated
      by reference to exhibit 10.1 to the Company’s Report on Form 8-K filed on
      February 4, 2009(10)
            Incorporated
      by reference to exhibit 10.2 to the Company’s Report on Form 8-K filed on
      February 4, 2009(11)
            Incorporated
      by reference to exhibit 10.27 to the Company’s Report on Form 8-K filed on
      August 6, 2004.(12)
            Incorporated
      by reference to exhibit 10.1 to the Company’s Report on Form S-1 filed
      April 30, 2009.




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